The US economy’s upswing over the last six years has been predicated on credit like the cycle before it because wage growth has been lacklustre. I want to describe where credit activity has created a lift in consumer spending and in capital investment that would otherwise have been absent. Afterwards, I want to describe where I think the weaknesses in this economic model lie and why I am inclined to believe we are closer to the end of cycle than near a mid-cycle slowdown a la 1994.
Warren Mosler has a term, “borrowing to spend” that he uses to denote the phenomenon of households borrowing money in order to maintain consumption. And in the wake of the recent INET conference in DC hosted at the IMF, I have some ideas on where this borrowing to spend has come from.
First, let me say this: banks are not just financial intermediaries that link scarce existing savings with investment opportunities as is often stated. The ‘loanable funds’ worldview underpinning this depiction of banks is a false paradigm. What actually happens at a bank is that every time it makes a loan and extends credit, it creates money out of thin air with the loan an asset to the bank and a liability to the borrower. In fact, this borrower can then go and deposit the full loan in the bank as savings if she so desires, without ever using it for investment or consumption. As a result, it is clear that savings was created by the act of lending rather than the act of lending being facilitated by existing savings. I think this is important to understand because it means that credit is critical to consumption and growth.
Before I go into how the borrow to consume model actually works, let me say one additional thing about how financial institutions operate. In the United States, before the civil war, there was a time when individual states or even banks issued bank notes that were usable as money. With bank money, it was clear that you held an asset that was a liability of a specific bank, meaning that you knew that the asset you held was subject to the solvency of the entity which issued it. But when state money supplanted other forms of money, this so-called free banking experience was also supplanted by a cartelization of banks who were able to issue state money by subjecting themselves to government regulation after getting a rationed bank charter license. So your deposit at a bank, which is still a bank liability, is transformed on demand into a state claim asset that can be used as legal tender and to expunge your tax liability.
Bank runs today, therefore, are a realization that we are still using bank liabilities and that those liabilities are worth less than state liabilities. They are the mass recognition that this transformation process from bank liability to state money cannot and will not occur indefinitely and on demand due to the insolvency of a specific institution. Deposit insurance has mitigated these runs by insuring most individuals that they can be made whole. But wholesale bank claims are a different story. ANd that is why the wholesale funding market was the locus of the most recent bank run.
These are issues that Janet Yellen touched upon at the INET conference at the IMF. But she did not contextualize them as I did because she used a loanable funds model of the world to present them as nearly every other presenter did at this forum.
Now, looking specifically at borrowing to spend, in the last real wage-led recovery in the 1990s, the mid-cycle slowdown of 1994, which the Fed precipitated by raising rates, was arrested due to the fact that real wages rose. My favourite pre-Lehman chart I did at Credit Writedowns shows real hourly earnings troughing just at this time.
When the 1990s boom ended, real hourly earnings continued to pick up but at a lesser pace and a lot of the missing consumption growth was filled by borrowing to spend via the infamous cash out refinancing housing ATM. And of course, as this was a more debt-fuelled cyclical upturn, the bust had significant lingering deleveraging effects that turned what Steve Keen calls the credit accelerator into a credit decelerator, risking debt deflation. This is why the Fed felt compelled to intervene in order to boost asset prices, particularly housing. But the result of a lack of household borrowing to spend along with stagnant wages has been anemic growth.
This is where the Kat Taylor presentation at the INET conference comes in. I had never heard of Kat Taylor before this event but her presentation as head of Beneficial State Bank impressed me. She pointed to an unfolding debacle in auto subprime mortgages that mirrors what we saw in housing in the decade before. I have written about auto subprime as a locus of froth before but she talked about it from the lending side. And her point was that subprime is a predatory market because of widespread mispricing of risk due to misaligned incentives. Subprime borrowers receive rates for loans that are higher than they should be because there are incentives for loan salesmen to sell the higher priced product in order to collect fees. Moreover, a considerable amount of the loan repayment and default statistics are not captured in FICO scoring data, further leading to mispricing. And the result then is people get into loan deals that make them for susceptible to default than if we had a properly functioning market for subprime households.
Why does this matter? Because of borrowing to spend. There are a number of areas where households feel compelled to spend where often their wages are insufficient to make purchases. These are: housing, transportation, and education. And in fact, these are the areas where the household credit ‘bubbles’ of the last decade are centered. The last bubble was in housing, And this decade, we are seeing auto subprime and student loans.
The housing bubble is in the past and I have talked about the auto subprime problem in the past. So I want to move on to student debt here, especially because it is such a large market. In a down economy, in which education matters in terms of wages, there is going to be a lot of demand for higher education. And this is a driving factor behind the boom in student loans. From an economic perspective, the boom in student loans acts like any other credit boom in creating savings out of thin air that can be used to consume or invest. Thus, what we are seeing with auto subprime and student loans is a “borrowing to spend” dynamic that is likely unsustainable.
Ask yourself, what would the economy of the United States have looked like from the period between 2009 and 2015 if we didn’t have the following five credit market booms: housing refinance activity, subprime auto, student loans, leveraged loans especially for shale oil, and high yield bonds especially for shale oil as well. I believe that without these five credit booms, the U.S. economy would have been significantly weaker.
Moreover, the question then becomes how sustainable are each of these booms. Here, I would say that in each case for different reasons, the booms are not sustainable. Janet Yellen herself pointed out the froth in high yield and leveraged loans at INET on Wednesday. This boom is entering its endgame. The housing refinance boom is now over and done. That leaves auto subprime and student loans to continue the borrowing to spend dynamic.
My conclusion here is that we will need to see more wage growth going forward because the fuel for the borrowing to spend boom in this cycle is largely spent. And while it is comforting that the unemployment rate has now dropped to 5.4% in data released as I was writing this post, I am not convinced we actually are near so-called full employment, heralding a revival in wages. If we do get there and wages get a lift, this cycle will continue as it did after the pause in 1994. If not, I would expect economic weakness to become entrenched and eventually infect the jobs and jobless claims numbers, without any obvious way politically to boost the flagging economy.
Borrowing to spend has been a significant factor in this up-cycle thus far. I believe it has diminished in importance and that this connotes weaknesses that are already evident in the data flow. And while weather was a significant factor in why Q1 data were so weak, there are real economy factors at play both in borrowing to spend and borrowing to invest in shale that mean data will not be as strong in mid-2015 as they were in mid-2014. I am not talking about recession, rather weakness that may well be the beginnings of the end-of-cycle that we last saw in 2006.