Flow of Funds indicates businesses have stopped deleveraging

The Federal Reserve released the quarterly flow of funds report which allows one to see the debt levels outstanding in the U.S. economy. From the looks of it, deleveraging has not continued apace.

UBS’ Andy Lees writes:

The Fed Z1 flow of funds report for Q4 just released. Total nonfinancial sector debt grew by 5.1% on an annualised basis. For 2010 as a whole debt was up 4.6%. Households did reduce debt so that was positive, but only by 0.6%. Business increased debt by 3.6% – (this could be seen as positive or negative depending on the return on its investments). States and local governments increased their debt by 7.9% whilst Federal debt grew by 14.6%, which I find hard to believe was invested in productive assets. In my opinion these figures are not indicative of the restructuring that is urgently needed and suggest that a continuation of this policy will result in stagflation as resource constraint mean there simply is no more road to kick the can down.

Now, I know a lot of people have pointed to student loan provisioning by the government for the latest increase in consumer credit. But I believe a balance sheet recession ebbs and flows. During a cyclical upswing deleveraging ebbs and during a cyclical downturn it flows, meaning we see the bulk of a balance sheet recession’s deleveraging during downturns. Now Richard Koo was decrying policies like QE2 recently because it creates an environment which magnifies this ebb and flow. But isn’t that inevitable? Doesn’t the monetary authority move last and too late both on the way up and the way down?

See my post, "Back to the global imbalances norm" where I give my seven assumptions about crisis policy responses.

• Kicking the can down the road is par for the course.
• Monetary and fiscal stimulus work on a cyclical basis at least. 
• Government has a vested interest in the status quo.
• When bad things happen, government has the power to make these things go away by changing rules.
• Doom merchants lose credibility by not appreciating this.
• Usually, forestalling doesn’t become prevention.
• Pollyannas will eventually also lose credibility.

The Flow of Funds data support this thesis that deleveraging has attenuated, that the relatively more optimistic psychology of businesses and consumers is supporting consumption and debt accumulation – at least for businesses. Businesses have repaired balance sheets but households’ balance sheets are still weak. Consumers are still deleveraging.

Question: if you take away the growth in federal spending, what would this flow of funds look like? And what would GDP growth look like?

My take: This is about cronyism and the present political debates about the size and role of government. The Obama Administration is seen as having used ‘Keynesian’ stimulus as a primary tool in dealing with the crisis. In my opinion, it is relatively certain the economy would be in worse shape if they hadn’t done so. The same goes for the liquidity provided in QE1.

The problem is the way it was done and why this invariably leads to a certain disgust in the electorate. In both cases, in terms of the Obama Administration and the Fed, you saw the Predator State at work, meaning policies favoured certain groups over others. I am thinking principally of freebies for too big to fail banks. Now I think the fiscal stimulus was too small and not targeted enough. Half of it was tax cuts, which means it helps saving and deleveraging which is good but doesn’t help reduce unemployment or increase GDP in the near-term.

But that’s neither here nor there when the bailouts are the major ‘stimulative’ activity that the electorate sees. That’s where the problem is. And while Tim Geithner says these ‘deeply unpopular, deeply hard to understand’ policies were necessary, doing things this way ensures that stimulus is discredited as a policy tool. The point being that, if you are destined to get government-sponsored cronyism in a deep downturn as the government increases spending, you are also likely to get stimulus revulsion and that necessarily undermines the ability to provide any additional stimulus, whether it helps or not. What I am saying is that the move into deficit hawk territory and the (often false) arguments used to support this move are enabled greatly by cronyism. The cronyism makes these arguments persuasive and fatally undermines any attempts to use government as a tool to diminish the impact of underemployment.

In my opinion, cronyism and resource misallocation is less important when the output gap from underemployment is large in a deep downturn like the one we have had. I would err on the side of increasing employment in order to close the output gap, even if that meant some level of government waste and/or cronyism and resource misallocation. The alternative is to allow labour to sit idle and thus miss out on tens of billions in potential production. This is why I have said any additional stimulus must be oriented toward employment.

But when people see the government giving out freebies, while government debt levels rise and unemployment remains high, the natural human reaction is revulsion.