Economist Insights Indebted - UBS
Asset management
13 May 2013
Economist Insights Indebted Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management [email protected]
The universal conclusion seems to be that there is too much debt and not enough savings. This is preposterous as one person’s debt is another person’s savings and, in the global economy, the total stock of financial assets will equal financial debt. It is easy to see how the transition from leveraging to deleveraging led to a recession but this does not explain why growth has remained weaker since. As banks and other financial institutions work to repair their balance sheets, are they properly intermediating between savers and borrowers and facilitating an efficient allocation of resources?
Everyone argues about debt and deleveraging, but the universal conclusion seems to be that there is too much debt and not enough savings. Unfortunately, this is preposterous. It is like saying that there are too many people having their hands shaken and not enough people shaking other people’s hands. One person’s debt is another person’s savings. When you deposit money in a bank, you are lending money to the bank; your savings become its debt. The bank then lends that on to others, creating another level of debt and savings. When you buy a treasury bond you are lending to the government. When you buy shares in a company you are effectively lending money to the company (repaid in dividends and part ownership). Ultimately, all that money is used somewhere. It may not be used in your own country but then it could pass to another country. In the global economy, savings will be equal to investment. In the same way, total stock of financial assets will equal financial debt. Debt is in fact a good thing in general; it allows the world to function the way people would like. In other words, debt facilitates an efficient allocation of resources. Debt allows you to smooth your income and purchase a home; it allows entrepreneurs to access capital. Debt allows governments to cushion the impacts of recession and invest in infrastructure; it allows poor countries to borrow from rich countries. Debt becomes a problem when the underlying asset is mispriced, because the mispricing leads to a resource misallocation. Misallocation takes many forms: mortgages too big to be paid off, too much capital invested in particular sectors (such as dot-com stocks), insufficient savings in pension funds, ever-increasing government debt.
Gianluca Moretti Fixed Income Economist UBS Global Asset Management [email protected]
When resources are misallocated an economy will grow more slowly or even shrink. The US consumer has been the poster child for runaway debt, bingeing on mortgages and cheap consumer credit until the bubble burst. But households in the US have made big progress in deleveraging. Debt has now fallen from over 140% of disposable income down to just over 110% (see chart 1). But surely the US consumer has more deleveraging to do, and surely this must mean slower growth. Well, just as importantly as the fall in the level of debt, the burden of servicing that debt has fallen even more dramatically. As a share of disposable income, interest and principal payments on debt have fallen from a peak of 14% of disposable income to a bit over 10%. Those interest rate cuts by the Fed are clearly having some impact. Chart 1: Room service Household debt service payments (interest and principal) as a percentage of disposable income 14.5
150
14.0
140
13.5
130
13.0
120
12.5
110
12.0
100
11.5
90
11.0
80
10.5
70
10.0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
60
Debt service (lhs) Source: Federal Reserve
Debt to disposable income (rhs)
Chart 2: Path-logical Illustrative example of interaction between consumption growth and leveraging or deleveraging Consumption growth +20%
0%
-20%
Income and consumption
120 100 100
100 100
120
100
120
100
-20
120
100
-40
Income Consumption Debt
100
-60
100 100
-80
100
-80
100
80
-60
80
-40
Source: UBS Global Asset Management
Change can hurt There is a common misperception that economies will not grow as quickly simply because they are deleveraging. The suggestion is that the act of paying down debt leads to slower growth. In short, a higher savings rate is meant to mean lower growth. If this is true, someone should tell China because it has both the highest savings rate and the highest growth rate amongst large economies. If anything, a high savings rate allows higher investment, and higher investment can support growth.
consumption falling by 17%. Shifting to a stable path has resulted in negative consumption growth, but debt is not falling. To get debt down you need to cut consumption to below your income. Consumption declines by 20%, but now debt is falling. Switching to deleveraging does indeed hurt growth. If you continue with your spending at the same level, debt will continue to fall but of course consumption growth is zero. Once you have transitioned to a deleveraging path you do not get the same effects on consumption growth.
In fact, it is not the act of paying down debt in itself that slows you. Rather, the slowdown in growth is caused by changing from a path where you are leveraging up to one where you are deleveraging (or simply leveraging up more slowly). Consider the simplified example in chart 2. Suppose your income is 100, and remains unchanged. As long as your consumption is 100 your debt will not be changing, and consumption growth will be 0%. But suppose that you decide to borrow to increase your consumption to 120. This is a growth in consumption of 20%, but you have also built up debt of 20. So shifting to a path of leveraging up increased consumption. Then suppose that you continue to spend 120 in the following years. Consumption growth is now 0% because consumption is unchanged, but your debt is still rising by 20 every year. Being on the leveraging path does not increase consumption growth.
It is easy to see how the transition from leveraging to deleveraging could lead to a recession, as happened in 20082009. But this does not explain why growth has remained weaker since then. Part of the answer no doubt is uncertainty amongst business that has suppressed investment, but a large part of the answer has to be the problems in the financial system. The purpose of the financial system is to channel money from savers to borrowers – in other words to create debt and thereby allocate resources. When debt levels were high and much of that debt was mispriced, balance sheets within the financial system became impaired. As banks and other financial institutions work to repair those balance sheets they will not be properly intermediating between savers and borrowers, so resources are not being properly allocated. Luckily for the US, its banks are much further along in repairing their balance sheets. Combine that with a much improved household balance sheet and you get a strong foundation for growth. It is a shame that Europe cannot say the same.
Eventually you decide that your debt is too high, so you cut your spending back to match your income. This leads to
The views expressed are as of May 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fundspecific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered “forward-looking statements”. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management’s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. © UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23033
13 May 2013
Economist Insights Indebted Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management [email protected]
The universal conclusion seems to be that there is too much debt and not enough savings. This is preposterous as one person’s debt is another person’s savings and, in the global economy, the total stock of financial assets will equal financial debt. It is easy to see how the transition from leveraging to deleveraging led to a recession but this does not explain why growth has remained weaker since. As banks and other financial institutions work to repair their balance sheets, are they properly intermediating between savers and borrowers and facilitating an efficient allocation of resources?
Everyone argues about debt and deleveraging, but the universal conclusion seems to be that there is too much debt and not enough savings. Unfortunately, this is preposterous. It is like saying that there are too many people having their hands shaken and not enough people shaking other people’s hands. One person’s debt is another person’s savings. When you deposit money in a bank, you are lending money to the bank; your savings become its debt. The bank then lends that on to others, creating another level of debt and savings. When you buy a treasury bond you are lending to the government. When you buy shares in a company you are effectively lending money to the company (repaid in dividends and part ownership). Ultimately, all that money is used somewhere. It may not be used in your own country but then it could pass to another country. In the global economy, savings will be equal to investment. In the same way, total stock of financial assets will equal financial debt. Debt is in fact a good thing in general; it allows the world to function the way people would like. In other words, debt facilitates an efficient allocation of resources. Debt allows you to smooth your income and purchase a home; it allows entrepreneurs to access capital. Debt allows governments to cushion the impacts of recession and invest in infrastructure; it allows poor countries to borrow from rich countries. Debt becomes a problem when the underlying asset is mispriced, because the mispricing leads to a resource misallocation. Misallocation takes many forms: mortgages too big to be paid off, too much capital invested in particular sectors (such as dot-com stocks), insufficient savings in pension funds, ever-increasing government debt.
Gianluca Moretti Fixed Income Economist UBS Global Asset Management [email protected]
When resources are misallocated an economy will grow more slowly or even shrink. The US consumer has been the poster child for runaway debt, bingeing on mortgages and cheap consumer credit until the bubble burst. But households in the US have made big progress in deleveraging. Debt has now fallen from over 140% of disposable income down to just over 110% (see chart 1). But surely the US consumer has more deleveraging to do, and surely this must mean slower growth. Well, just as importantly as the fall in the level of debt, the burden of servicing that debt has fallen even more dramatically. As a share of disposable income, interest and principal payments on debt have fallen from a peak of 14% of disposable income to a bit over 10%. Those interest rate cuts by the Fed are clearly having some impact. Chart 1: Room service Household debt service payments (interest and principal) as a percentage of disposable income 14.5
150
14.0
140
13.5
130
13.0
120
12.5
110
12.0
100
11.5
90
11.0
80
10.5
70
10.0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
60
Debt service (lhs) Source: Federal Reserve
Debt to disposable income (rhs)
Chart 2: Path-logical Illustrative example of interaction between consumption growth and leveraging or deleveraging Consumption growth +20%
0%
-20%
Income and consumption
120 100 100
100 100
120
100
120
100
-20
120
100
-40
Income Consumption Debt
100
-60
100 100
-80
100
-80
100
80
-60
80
-40
Source: UBS Global Asset Management
Change can hurt There is a common misperception that economies will not grow as quickly simply because they are deleveraging. The suggestion is that the act of paying down debt leads to slower growth. In short, a higher savings rate is meant to mean lower growth. If this is true, someone should tell China because it has both the highest savings rate and the highest growth rate amongst large economies. If anything, a high savings rate allows higher investment, and higher investment can support growth.
consumption falling by 17%. Shifting to a stable path has resulted in negative consumption growth, but debt is not falling. To get debt down you need to cut consumption to below your income. Consumption declines by 20%, but now debt is falling. Switching to deleveraging does indeed hurt growth. If you continue with your spending at the same level, debt will continue to fall but of course consumption growth is zero. Once you have transitioned to a deleveraging path you do not get the same effects on consumption growth.
In fact, it is not the act of paying down debt in itself that slows you. Rather, the slowdown in growth is caused by changing from a path where you are leveraging up to one where you are deleveraging (or simply leveraging up more slowly). Consider the simplified example in chart 2. Suppose your income is 100, and remains unchanged. As long as your consumption is 100 your debt will not be changing, and consumption growth will be 0%. But suppose that you decide to borrow to increase your consumption to 120. This is a growth in consumption of 20%, but you have also built up debt of 20. So shifting to a path of leveraging up increased consumption. Then suppose that you continue to spend 120 in the following years. Consumption growth is now 0% because consumption is unchanged, but your debt is still rising by 20 every year. Being on the leveraging path does not increase consumption growth.
It is easy to see how the transition from leveraging to deleveraging could lead to a recession, as happened in 20082009. But this does not explain why growth has remained weaker since then. Part of the answer no doubt is uncertainty amongst business that has suppressed investment, but a large part of the answer has to be the problems in the financial system. The purpose of the financial system is to channel money from savers to borrowers – in other words to create debt and thereby allocate resources. When debt levels were high and much of that debt was mispriced, balance sheets within the financial system became impaired. As banks and other financial institutions work to repair those balance sheets they will not be properly intermediating between savers and borrowers, so resources are not being properly allocated. Luckily for the US, its banks are much further along in repairing their balance sheets. Combine that with a much improved household balance sheet and you get a strong foundation for growth. It is a shame that Europe cannot say the same.
Eventually you decide that your debt is too high, so you cut your spending back to match your income. This leads to
The views expressed are as of May 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fundspecific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered “forward-looking statements”. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management’s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. © UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23033
