Balance Sheet Recessions and The Psychology of Deflation
The chart below is from today’s morning Breakfast with Dave missive by Gluskin Sheff’s David Rosenberg.
How do you fight against losses this large? Like Richard Koo and David Rosenberg, I believe the monumental hit that balance sheets of American households have taken is the kind of thing that will result in marked changes in consumption and savings. These changes do not happen overnight because humans are creatures of habit. They take years to become manifest – with successive downturns and short business cycles as the major contributing factors.
Earlier this month, while reading the Sunday Washington Post, I was struck at how ingrained the psychology of deflation had become in the housing market – even in Washington D.C. where the economy has done relatively well. I wrote a post on it, highlighting the juxtaposition in post-bubble seller psychology and buyer psychology. My conclusion was that sellers are still anchored to pre-recession higher prices – many because of the need to cover mortgages associated with those prices. On the other hand, the swift move down in prices and interest rates has already pre-conditioned buyers to wariness.
The row house is one of many homes competing for [the prospective homebuyer’s] attention in uncertain economic times. She’s been looking to buy a home in the District since April but is in no rush to commit, partly because she thinks mortgage interest rates – and prices – could sink even lower.
My conclusion: Seller’s minimum last ditch sale "reservation point" is still too high for buyers. After the initial wave of distress, the result has been a collapse in sales rather than a dramatic fall in house prices. In the aggregate, house prices nationally are not far above median levels on a price-to-rent or price-to-income ratio. In some devastated areas, prices are below median levels. But there is already an 11-month inventory of existing homes on the market and a huge backlog of shadow inventory. The psychology of deflation is a good reason why house prices will continue to fall as this inventory hits the market.
From a consumption perspective, the changes in psychology are already apparent – nothing drastic (People are refraining from that extra meal out, for example). But this has been enough to slow growth. One article in USA Today that Rosenberg cites a few ways psychology has changed.
Fewer people are moving. The share of people who haven’t changed homes in the previous year climbed from 83.2% in 2006 to 84.6% in 2009.
•Delaying marriage. For the first time since the government began tracking the data, the share of women 18 and older who are married fell below 50%. "The recession has accelerated the trend," Mather says. "A lot of these young adults are choosing to live together rather than get married. It’s kind of an adaptive response to the lack of jobs and economic uncertainty."
The share of adults ages 25 to 34 who have never married has jumped from 34.5% in 2000 to 46.3% in 2009, his analysis shows.
•Cars and home offices. The share of homes that have more than one car dropped, but the proportion of workers who worked from home jumped from 3.9% in 2006 to 4.3% last year. "The recession is altering behavior," Lang says. "It’s the downsizing of America."
•Demand for higher education. The percentage of people holding a bachelor’s degree or higher edged up to 27.9% in 2009, another potential effect of the recession. "You finish your bachelor’s degree and there’s no job available," Mather says. "More people are going for master’s or some kind of professional degree."
•Income inequality. The gap between the rich and poor was unchanged in 2009 from 2008.
Question: what happens if a slow but multi-year recovery forms? I think a lot of the psychology change would dissipate – both in terms of deflation-thinking and in terms of reduced consumption. Think about the period after 2001 in the United States. We now know that this was a period of stagnating income growth and anaemic job creation. Yet because the economy was growing, asset prices were rising, and interest rates were low, people felt free to spend. Why would it be any different in the next multi-year recovery?
All I’m saying is that it is the economic stress of recession which creates and perpetuates the psychology of deflation and depression. And given high private sector debt and the limited policy options available to reflate, a recession now means a deflationary mindset of holding off consumption and anticipating further price declines would become entrenched. This is what policy makers are ostensibly looking to avoid. I don’t think they can given the self-imposed political constraints. By early 2011, we will know for sure. If and until then, expect a muddle through.
Recessions brought about by high interest rates abate when rates come down. This recession is a balance sheet recession caused by a bubble in housing, hundreds of billions if not trillions in suspect mortgages, which then turned into a financial crisis.
This is a unique business cycle, and there aren’t many fixes available to fiscal or monetary authorities. Deleveraging will likely continue, and the huge amount of excess reserves sitting in bank vaults won’t be lent out anytime soon. Double-dip? I doubt it, but the recovery will stay in the slow lane
Charles Sherry
https://www.economy-tomorrow.com
“Think about the period after 2001 in he United States. We now know that this was a period of stagnating income growth and anaemic job creation. Yet because the economy was growing, asset prices were rising, and interest rates were low, people felt free to spend.”
MEW. Back it out and recession for a few years. How much mortgage equity exists now?
Right, growth would have been much less without the asset price appreciation. The question now is what kind of growth we can expect in its absence OR should we expect its absence?
For example, right now the bond market is rising, especially higher yielding bonds of lower quality. Companies are issuing a record amount of debt to lock in low yields – this despite a massive increase in cash on the balance sheet. Is this something that can buoy consumption in the absence of income growth? I am sceptical. I think the last major bubbles which contribute meaningfully to consumption growth are behind us. And in its place we have a weaker economy more susceptible to exogenous shocks. That says business cycles should be shorter and average growth lower.
Yet because the economy was growing, asset prices were rising, and interest rates were low, people felt free to spend. Why would it be any different in the next multi-year recovery?
Credit availability and reliance on credit to draw demand forward are key factors in consumer spending, which constitutes a major portion of GDP and drives investment, which is based on demand expectation.
Both lenders and borrowers are operating from a different mindset than they were pre-2008. The consumer binge of the 2000’s was credit-driven. What is going to drive consumption in the anticipated recovery when job growth is expected to be weak, hence incomes lagging? I don’t see a resumption of the credit binge anytime soon and there is nothing on the horizon to take its place.
Moreover, this is the wind down of a long financial cycle and there is a lot of deleveraging yet to take place, and consumers also need to rebuild balance sheets with savings. This is not an ordinary business cycle recession and the recovery is going to be different, too.
Edward,
The problems with inflation are as you say here and elsewhere. It amplifies the burden of debt and it discourages investment. Each of these has a remedy other than waiting it out. The burden of debt can be relieved by writing it down, making the lenders take a hit. In particular, with regard to housing, the Home Owners Loan Corporation model of the 1930’s which Kuttner and Stiglitz and others recommended two years ago could relieve the burden of debt. With regard to the discouragement of other investment. This would seem to be a stickier wicket when countries like China are subsidizing new investment as a means of stimulus, but the obvious investments in public goods like infrastructure, education, energy conservation, and so on, are investment that has no competition from deflating assets.
As a working man, I am befuddled at econmists who look at the current and prospective stagnation and say we need to wait it out. This seems only to benefit the banks. Write-downs would expose their bad lending. Even European sovereign debt ought to be rationally restructured, but won’t be, because it would expose the banks there.
When you have excess capacity like we do and obvious needs like we do, the only reason not to get to work on the obvious work that needs to be done is to further coddle the financial sector. It’s like feeding the monster at the gate rather than slaying it and opening things up. I am very discouraged that economists and intelligent observers like yourself have resigned themselves to a decade of stagnation and no doubt social unrest.