Household Balance Sheets

Recently, I’ve noticed various financial commentators speaking about the household balance sheet. In my opinion, it seems as though there are quite a few errors in reasoning, especially with regards to debt. I don’t have time to examine all of them, so I will address the important ones. My initial comment regards the use of the term “net debt”, as I don’t think it’s appropriate when examining the household balance sheet. Net debt, in a microeconomic sense, is defined as short term debt + long term debt – cash & cash equivalents. When examining the household balance sheet, calculating such a number would be extremely difficult, as determining “cash equivalents” would be ambiguous, at best. Is one to include pension funds in such a number? They are, after all, quite illiquid, depending on your age. And even so, the number would almost never be positive, making the debt seem irrelevant. But let us not forget that non-cash asset values can be dubious and subjective, whilst debt can not. It must be serviced, and the measure of the ability to service this debt, depending on maturity, is usually based on elements such as short term assets and earnings, amongst others (this is true for both companies and households). Most established economists use total debt as a percentage of disposable income as a benchmark for this reason. And by this measure, U.S. households still have a lot of deleveraging to do. As of the end of 2009, total household debt stood at 122.5% of annual disposable income, down only marginally from a peak of 130.6% at the beginning of 2008 (Economists tend to see 100% as a sustainable level).

Many comments on household net worth seem to be used improperly. One must examine how household net worth is measured, and question the reliability of asset values on the household’s balance sheet. The alarming aspect of the situation is the trend of debt vs. assets or income, as well as the shift in type of assets (towards riskier assets). Ken Rogoff is, for the most part, worried about this trend, and with good reason. Allow me to demonstrate my analysis.

Based on recent (2009) Flow of Funds Statistics, US household net worth was roughly $54 trillion. Assets stood at roughly $68 trillion – made up of $45 trillion in financial assets and $23 trillion in tangible assets. Liabilities stood at roughly $14 trillion. Of the $45 trillion in financial assets, roughly $30 trillion were in the form of equities or equity equivalents, including corporate equities, mutual funds, equity in non corporate businesses, pension funds etc. Roughly $8 trillion were held in credit market instruments, including open market paper, treasuries and corporate and foreign bonds. Only $7 trillion were held in deposits, which includes currency, checkable deposits, money market funds etc. In 1980, based on Flow of Funds Statistics, US household net worth was roughly $10 trillion. Assets stood at roughly $11,4 trillion – made up of $6.5 trillion in financial assets and $4,9 trillion in tangible assets. Liabilities stood at roughly $1,4 trillion. Of the $6,5 trillion in financial assets, $4 trillion were held in equity or equity equivalents; roughly $1 trillion in credit market instruments, and $1,5 trillion in deposits.

Multiple conclusions can be drawn from this brief analysis. First, we notice that whilst assets have increased by a factor of 6, liabilities have increased by a factor of 10. Further analysis indicates that, in the 1970 and 1980s, consumer credit was in majority made up of non-revolving credit, to the tune of almost 98%. Today, non revolving credit is only 70% of consumer credit. This means, simply, that 30% of total consumer credit will become much more expensive to service should interest rates rise. Additionally, we can see that whilst, in 1980, roughly 40% of total assets were tangible, in 2009, this had dropped to 29%. Equities, or equity equivalents, increased to roughly 50% of the total, up from 35% in 1980. The conclusion from this analysis is simple: the average US household has shifted towards riskier assets, and has, on average, increased debt more rapidly than assets (and assets were increasing at unsustainable rates). As is the case with all balance sheet analysis, we must examine the quality of the assets in order to estimate the validity and sustainability of NAV.

Why is this worrisome? Currently, most of household “wealth”, and the increase in this wealth, is made up of financial assets. Between 1982 and 1999, the large general rise was largely due to the unprecedented rise in capital markets – mostly equities; from 1999 to 2007, the rise in household assets was largely due to an unprecedented rise in home prices. Both of the rises were far beyond what fundamentals indicated. In short, much of the rise in household wealth over the past 30 years seems to be the result of various asset bubbles, none of which are sustainable over long periods. Individuals who believe that the markets, whether capital or real estate, will move back into long term parabolic rising phases right away may be disappointed (especially in real, inflation adjusted, terms). And whilst the asset values of US households are only a partial measure of actual real wealth, the debt of households is very real, and has been rising at alarming rates. In truth, total US household debt, including both consumer and mortgage debt, has increased from roughly $1,4 trillion in 1980, to $14 trillion in 2009. Often, the trend is just as, if not more, important than absolute change. Recent arguments are similar to those of CNBC pundits in 2005 and 2006. They pointed out that the debt was manageable because Americans had so many “assets”. Only a small number of economists (Marc Faber, Robert Shiller and others), pointed out that the value of those asset was illusionary. Many thought they had enormous amounts of wealth, but it was “unrealized wealth”, and once the bubbles burst, and asset prices came down, it would become obvious that their levels of debt were unmanageable. Now, as was the case in 2002, a pro-stimulus and low interest rate environment has caused another large rise is capital markets, and once again, individuals make the same mistake of assuming that everything is back to pre-crisis norms, and debt is completely manageable again. What if growth doesn’t return to those levels? What if, once the effect of corporate cost cutting wears off, top line doesn’t follow, leading to sub-2007 earnings? What if interest rates begin to rise in a dramatic manner at some point over the next 3-5 years? Intelligent investors are, by nature, skeptical. They focus on downside potential first.

There’s nothing inherently wrong with increasing exposure to riskier assets, as long as downside is taken into account via provisions. The alarming decline in savings over the past two decades, in conjunction with increase in general levels of debt, is the issue in question. It leaves the average household with very little wiggle room, and forces them into a difficult situation (forced selling of financial assets; restrained consumption etc.) in order to service their increasing debt when things go wrong. Real wealth, sustainable wealth, should come in majority from more sustainable means, such as income (whether work or investment related), not increases in paper assets like stocks. US household nominal income has increased by a factor of 2-3 times (depending on the demographic) since the early 1980s (only 35% in real inflation adjusted terms…inc/h06ar.html). When we examine this next to debt increases, the the situation cannot be ignored. It paints a clear picture of how US households finance their consumption, and seemingly increasing standards of living.

Even after the crisis, the majority of household debt is still there, whilst interest rates have hit generational lows. These are, by all measures, unsustainable. As interest rates begin to rise, so too will the servicing costs of revolving household debt. From a historical perspective, US household debt as a percentage of assets is too high, debt service ratios are too high and household debt as a percentage of GDP is too high. Rogoff’s point, which is valid, is that the consumer has hardly de-leveraged since the start of the crisis, and must do so. This Balance Sheet recession will likely lead to anemic growth in the economy for some time. As the US household continues to de-leverage, the Keynesian system assures that the government will have to continue to run a budgetary deficit or a trade deficit, or both. In any event, the outcome is not a positive one for the US as this will, in fact, shift the problem from the consumer balance sheet to the government balance sheet, creating what could be another asset bubble, potentially in government securities. Of course, nobody is saying that the US will default on these obligations, instead, it will likely “print money” to attempt to resolve the situation, the result of which will be much higher price and/or asset inflation (I’ve noted before that I’m not yet a believer in the hyperinflation scenario based on current evidence). It was able to avoid this over the past 20 years as a result of a different method of financing government debt: deficit finance bonds sold to private investors through existing financial markets. This placed the bonds in the hands of investment funds, or foreign central banks, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization. The result was asset price inflation as opposed to price inflation. This may not be the case going forward.

In sum, these are the reason why Rogoff, and many other economists, are nervous going forward. I believe them to be justified, as evidenced by the points above.

Also, please note that we are not including the national debt as a liability when calculating household net worth. As such it becomes an off balance sheet liability for households; that is definitely not the proper way to account for it.

If you have any questions, let me know.



U.S. Federal Reserve – Flow of Funds report
U.S. Census Bureau
U.S. Treasury – Bureau of the Public Debt

~ by eboro on August 1, 2010.

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