Saturday, May 30, 2009

Warning: Painful Household Deleveraging Ahead

American households have embarked on a process of debt reduction that could take years to complete, based on historical comparisons, according to a study by the San Francisco Fed. This deleveraging will be painful whether it is from belt-tightening to increase savings and reduce debt -- or through foreclosures, short-sales of homes or bankruptcies. This seems to suggest that the economic recovery that is on the horizon will be weak and that gains in economic growth could be terribly slow in coming.

By Robert Stowe England

May 30, 2009

Americans have been living beyond their means for so long that they can no longer do so. They have, in fact, begun a long and likely painful process of deleveraging or debt reduction that could last for many years.

Economists measure household frugality or profligacy by calculating the ratio of debt to personal disposable income. In 2007 that ratio for the average American household reached an all-time high of 133 percent. By contrast, in 1960 the ratio stood at 55 percent.

As households deleverage and build up their savings to overcome sharp losses in home equity and investments, consumption by the household sector is likely to be weak in the coming recovery, according to economists Reuven Glick and Kevin J. Lansing of the Federal Reserve Bank of San Francisco.

Their observations were made May 15 in the FRBSF Economic Letter in an article titled "U.S. Household Deleveraging and Future Consumption Growth."

Glick and Lansing cited economist Hyman Minsky who proposed more than two decades ago a financial instability hypothesis asserting that prolonged good economic times induce behavior that leads to really bad economic times. As Glick and Lansing explain in economics lingo, Minsky "argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions."

The long trek of American households to record leverage has taken nearly five decades. However, most of the excessive leverage has occurred since the 1980s, when leverage still stood only at 65 percent.

Glick and Lansing look at historical experiences to see just how much deleveraging might be in store for American households and the U.S. economy. During the early years of the Great Depression, from 1929 to 1933, for example, nominal debt held by households declined one-third.

In Japan, evidence from the leverage of private non-finanical firms after the bursting of the real estate bubble and stock market bubble showed a 30 percent decline of the same magnitude over a ten-year period. The authors suggest, in fact, that it could take American consumers until 2018 to reduce their leverage by 25 percent, from 133 percent to 100 percent, the level where it stood in 2002.

Given the sharp pace of home price declines and the high level of foreclosures, the process this time around seems more like the pace and rate of decline in household leverage during Great Depression rather than the slower pace of decline in Japan after 1991.

Given the magnitude of losses in home equity and in the stock market, it would seem to this writer that the period of deleveraging and reduced consumption by households will last much longer than three years for the great majority of American households. For those going through foreclosures, short sales of homes and bankruptcies, the rebalancing act will take place much faster, but this will transfer the costs to financial institutions, again with consequences in the larger economy.

It would seem that whether the pace is fast or slow, nearly all households have already found that thrift and frugality are suddenly very, very attractive, if not irresistible. In the long run, these newly rediscovered virtues will pay off for households, the economy and society at large.

Meanwhile, the engine of economic growth -- the American consumer -- is not going to be running on all cylinders for quite awhile.

The San Francisco Fed article can be found at this link:

Copyright 2009© by Robert Stowe England

Wednesday, May 20, 2009

China Needs Bold Retirement Policy Reform

China's current retirement schemes are provided to only a distinct minority of workers, have limited portability, are mostly unfunded and deliver an inadequate benefit at retirement. To meet the challenge of an aging society, in which the elderly will constitute 24 percent of the population by 2030, China needs to start over with a new system that is universal and provides a better benefit at a lower payroll cost, according to economist Richard Jackson and fellow researchers at the Center for Strategic and International Studies.

By Robert Stowe England

May 20, 2009

"China needs to develop a [retirement] reform strategy every bit as bold as the demographic challenge about to overcome it," according to Richard Jackson, program director and senior fellow of the Global Aging Initiative at the Center for Strategic and International Studies (CSIS) in Washington, D.C.

Jackson offered his own bold proposal for reform at a policy forum yesterday (May 19) at CSIS.

The demographic challenge for China is "premature aging," Jackson said, meaning that China will grow old as a society before it has grown rich and, thus, will have a more difficult challenge in providing retirement income for an expected 24 percent of the population that will be elderly by 2030, just over 20 years from today. By 2050, people over age 60 will constitute 33 percent of the population.

The population shift is a result of efforts by authorities since the 1960s to dramatically reduce the bith rate, an effort that culminated with the declaration of the draconian one-child policy in 1980.

The current urban retirement system evolved from a series of reforms of the generous old enterprise-based system for state-owned enterprises (SOE) that before the mid-1990s provided a benefit of 80 percent of average local wages, which were quite low by today's standards. There is now a basic pension or first tier funded by a pay-as-you-go payroll tax of 20 percent and a second tier of personal accounts administered as a collective pool that is funded by an 8 percent required employee contribution.

Only about 31 percent of China's workforce "is earning a pension benefit of any kind," Jackson said. This is because the pension system is largely confined to the 37 percent of the population that lives in urban areas, while the 54 percent rural population is virtually uncovered by any retirement benefit and its elderly rely on their sons to take care of them, he said.

The current system is costly, amounting to 28 percent of payroll, because it includes legacy costs of laid-off workers in restructured industries, according to Jackson. Further, it is going to provide an inadequate benefit at a 35 to 40 percent replacement rate for the worker's average earnings, he noted. This is far lower than the 60 percent claimed by the central government.

The second tier of the current system also has another and perhaps more severe problem. Many of the accounts are mostly empty, even though funds have flowed from employees and employers into the accounts for many years now. The problem is that local and provincial governments that manage the decentralized social security system have been taking the funds in the second tier to pay out benefits in the first tier to current retirees.

The central government has been gradually funding the shortfalls in the personal accounts system from general revenues.

A detailed analysis of the current system and recommendations for reform are contained in a monograph China's Long March to Retirement Reform, written by Jackson and CSIS colleagues Keisuke Nakashima and Neil Howe.

Jackson told the forum that providing a much better benefit for the entire population of China would require that the government fund a new basic benefit from general revenues and take over the considerable unfunded liabilities of the current system.

By starting over with a new system for all workers, China will be able to provide a universal, portable and more adequate retirement benefit. The basic components would be as follows:

  • The new zero tier or social pension would be jointly funded from general revenues by the central government and the provinces and would provide a benefit equal to 20 percent of the local average wages.

  • The new, funded second tier of personal accounts would require an 18 percent mandatory payroll contribution rate. The projected benefit for the personal accounts system would be 50 percent of local average wages. (From the 18 percent payroll contribution, 16 percent will go to personal accounts and 2 percent for disability and young survivors benefits.)

The expected higher benefit also assumes that the contributions earn a market rate of return. In the existing system personal accounts earn a mandated rate of return that is extremely low.

By pre-funding its retirement system, China will have to spend less overall to meet benefit obligations and, thus, mitigate the drag on the economy that will come with the aging of the population, Jackson said.

The balances in the personal accounts will be personally owned and privately managed and invested. The system, however, would remain a public social insurance program regulated and supervised by the government.

The funded system will also help broaden and deepen China's capital markets and help assure the vast Asian nation will have sufficient capital for its needs at a time 25 years from now when some economists are predicting that China will have a capital shortage, according to Jackson.

The complete background report, with the proposed retirement reform, can be downloaded in pdf form at this link:,com_csis_pubs/task,view/id,5419/type,0/

Wednesday, May 13, 2009

First, Rein In Government-Induced Systemic Risk

Government – not the market – played the dominant role in creating the systemic risk we now face, and the government poses a greater systemic risk in the future. “Reining in this risk should be the highest priority, higher than creating a new systemic risk regulator,” says economist John Taylor.

By Robert Stowe England

May 13, 2009

In the ongoing debate about whether the market or the government played a larger role in the ongoing financial crisis, Stanford University economist John B. Taylor places the greater share of blame on the government.

Taylor, a Treasury undersecretary from 2001 to 2005, laid out his case last night (May 12) in a dinner keynote speech at the Federal Reserve Bank of Atlanta’s Conference on Financial Innovation and Crises at Jekyll Island, Georgia.

Taylor cites a number of government mistakes. At the top of the list is the Federal Reserve’s decision to keep interest rates too low too long in the period from 2002 to 2005.

Taylor faults policy makers for a misdiagnosis of the cause of the money market turbulence in the summer of 2007, which Taylor contends was a counterparty risk problem. The Fed wrongly assumed the trouble was caused by a lack of liquidity and therefore increased liquidity in the financial markets, he said.

“Hence, liquidity was pumped into the system and interest rates were slashed too rapidly which caused the dollar to depreciate and oil prices to skyrocket, a severe hit to the economy, especially the automobile sector,” Taylor said.

Taylor is author of the recently-published Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

The Stanford economist does not believe the aftermath of the decision to let Lehman Brothers fail strengthens the case for government regulation.

“Many in government now argue that the cause of the panic in the fall of 2008 was the failure of the government to intervene and prevent the bankruptcy of Lehman. This view gives a rationale for continued extensive government intervention—starting the very next day with AIG—and to proposals for a more expansive resolution process, whether in the hands of a new systemic risk regulator or the FDIC,” Taylor said.

“However, in my view the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector. This strategy could have been put forth in the weeks after the Bear Stearns rescue, but was not,” he said.

“Instead market participants were led to guess what the government would do in other similar situations. The best evidence for the lack of a strategy was the confusing roll out of the TARP plan, which, according to event studies of spreads in the interbank market, was a more likely reason for the panic than the failure to intervene with [Lehman Brothers],” Taylor said.

He also sees systemic risks in the huge run-up in federal deficits, a raft of bailouts and rescues from Treasury, the Fed and the FDIC, and a huge run-up in the Fed’s balance sheet.

Taylor also faults a leaked report from the Fed written up in the Financial Times (Krishna Guha, “Fed Study Puts Ideal Interest Rate At -5%,” Financial Times, April 27 2009).

The cited Fed article argued that the Fed’s Taylor rule calculations show that the interest rate should be -5 percent.

According to Wikipedia, “in economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank will or should change the nominal interest rate in response to divergences of actual GDP from potential GDP and of actual inflation rates from target inflation rates.” See more at this link:

“I have not seen the report and I do not know how the calculations were made, but they imply that the Fed may think it has plenty of time before positive interest rates and a reduction in reserve balances are required,” Taylor said. However, the calculations are “way off,” he added.

If one follows the Taylor rule, however, it would yield a plus 0.5 percent interest rate rather than a -5 percent rate in the leaked Fed article, according to Taylor.

“My calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate. We don’t know what will happen in the future, but there is a risk here and it is a systemic risk,” Taylor said.

What should be done now? Taylor’s remedy: “The emphasis should be on proposals to stop the systemically risky budget deficits projected as far as the eye can see, to exit from the extraordinary monetary policy actions, and to end the bailout mentality that is taking the federal government further and further into the operations of businesses and threatens the rule of law.”

“New legislation could then focus on preventing the monetary actions of the kind that led us into this crisis—perhaps a requirement that the Fed focus on the instruments of monetary policy and be accountable and transparent about it,” he added.

“First, state the objective of the monetary policy instruments—including each of the new instruments and facilities,” he told the conference attendees. “Second, say how they will be evaluated to determine whether the policy is meeting the objective; third report the results of evaluation.”

“More generally, government should set clear rules of the game, stop changing them during the game, and enforce them. The rules do not have to be perfect, but the rule of law is essential,” Taylor said.

Taylor’s complete remarks are available at the Atlanta Fed’s web site at this link:

Copyright 2009© by Robert Stowe England

Wednesday, May 6, 2009

An Action Plan for Troubled Assets

The $1 trillion Geithner public-private partnership investment plan offers a broad framework for using private-sector capital to enable price discovery and government-backed leverage to boost returns. Policy-makers hope the effort will move troubled assets off the balance sheets of banks.

By Robert Stowe England

Mortgage Banking

May 2009

Firefighters sometimes start a controlled fire ahead of a raging forest fire. The idea is to have the staged fire burn toward the dangerous out-of-control fire with the goal of stopping its advance by denying it a way to spread toward a protected target.

In a similar move, a new federal program -- the $1 trillion Public-Private Investment Program (PPIP) -- is designed to use leverage and the lure of very high investment returns (the proximate causes of the financial meltdown) to help begin to undo the damage done to the financial system, to banking and to the mortgage markets.

Here is a link to a read-only version of the story as it appears in the May issue of Mortgage Banking:

And here is a link to a printable text-only version of the story: