Some brief thoughts on releveraging and wage growth

As I mentioned last week, I am on a winter break. So I haven’t been able to post over the past several days. But I have been following the news flow and wanted to make a few comments on what I am seeing regarding the US.

I believe wage and income growth are the only sustainable inputs that drive an economy’s growth over the long term. Declining interest rates, declining savings rates and debt accumulation can go a long way toward sustaining growth. But eventually interest rates and savings rates fall to zero and debt accumulation causes service costs to become more than wages and income can support.

Over the past thirty-odd years in the United States, wage and income growth has been stagnant (i.e. secular stagnation) but the economy has grown as interest rates and savings rates have declined and household debt has risen faster than the growth rate of the economy. That is a very long time for stagnant wages and income to exist without it having serious ill effects on the macroeconomy. What this episode demonstrates is that unbalanced secular trends can last for decades without precipitating a depression or revolution or a hyperinflation. In that sense, the takeaway should be that the US political economy is robust and can withstand large shocks and large imbalances without imploding.

That said the recent data out of the US show a household releveraging that, from a cyclical perspective supports growth, but that I believe will be unwound as the credit cycle turns down. Notice two things, however. First, the releveraging is coincident with a decline in delinquency rates, meaning that as households are taking on more debt, bad debt ratios are declining. These ratios are counter-cyclical and are an amplifying factor that create the credit cycle. At some point, we should expect the economy’s growth rate to turn down enough to increase delinquency rates, which in turn will slow credit growth, which in turn will increase debt stress and delinquency rates further until we have a recession and serious credit downturn.

Second, debt service costs are at generation lows right now. And household debt and mortgage debt are down 17 and 21% respectively from cyclical peaks. That is supportive of credit growth. It says that, in the absence of debt stress, households have the capacity to take on more debt. Thus, from a cyclical perspective, I believe we are still in a delicate phase where it is unclear how the economy will move forward. Wage and income growth are not high enough to move us beyond stall speed. But inventory accumulation and credit growth added on top are. The question is whether those factors will continue to contribute to economic growth in 2014 or whether they recede. I believe that an inventory purge and/or household deleveraging will make the US vulnerable to a recession.

From a cyclical perspective, the areas that I believe are most vulnerable are the new subprime areas and local government debt. The latest data show the youngest cohorts borrowing a lot to support student loans, which are usually not dischargeable in bankruptcy. And this debt is concentrated amongst debtors with the lowest credit scores. What we are seeing then is a sort of hidden unemployment. Young people, unable to find work, go to school and take on debt doing so. The ones most affected by the employment situation are likely to be the same ones who are subprime borrowers who are also taking on the largest debt loads right now. I believe this is a serious vulnerability for the US economy, especially because these debtors will cut spending drastically to repay this debt since student debt often cannot be discharged in bankruptcy.

Note the following:

The US Bankruptcy Code at 11 USC 523(a)(8) provides an exception to bankruptcy discharge for education loans. This page provides a history of the legislative language in this section of the US Bankruptcy Code.

Student loans were dischargeable in bankruptcy prior to 1976. With the introduction of the US Bankruptcy Code (11 USC 101 et seq) in 1978, the ability to discharge education loans was limited. Subsequent changes in the law have further narrowed the dischargeability of education debt.

The exception to discharge for private student loans evolved over time. Prior to 1984, only private student loans made by a “nonprofit institution of higher education” were excepted from discharge. This was intended to protect the National Defense Student Loan Program (NDSL), the predecessor to the Perkins Loan Program. Those loans were made by colleges using a revolving loan fund created using matching federal contributions. The Bankruptcy Amendments and Federal Judgeship Act of 1984 made private student loans from all nonprofit lenders excepted from discharge, not just colleges, by striking the words “of higher education”. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded this to include all “qualified education loans”, regardless of whether a nonprofit institution was involved in making the loans.

Regarding the new subprime problem, I have already written on the auto situation. So the credit growth is not problematic only in student loans but also in auto loans as well. In the housing arena, where subprime blew up in 2007, the sector has shifted so that subprime is less of a problem.

On local government debt, the situations in Detroit and Puerto Rico are a harbinger of what is to come elsewhere when the economy in the US next turns down. The same pension issues and revenue shortfalls are going to crop up everywhere – and this will be a major source of unemployment and demand shrinkage.

These issues are going to be acute simply because interest rates are zero percent, savings rates are already low and only the low debt service costs due to low rates is allowing households to accumulate debt in the face of stagnant incomes. The problem, in short, is wage and income growth. The US has been able to growth despite stagnant incomes for years because of the fall in interest rates and savings rates. But that game is over. And the next recession won’t benefit from either of these factors. This is why it is imperative that we see wage growth in the US before the credit cycle turns down.

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