A Solid Foundation of Rising Asset Prices

Some of the best commentary from Paul Kasriel at Northern Trust comes on days when there are no economic reports. He and Asha Bangalore are usually on top of the economic news as it becomes available, giving it their own unique slant, however, on days when no economic news is scheduled for release, you find gems like this update to the personal savings rate.

In this commentary (.pdf) from a week ago, readers not only get a clear and concise explanation of the oft-misunderstood savings rate, but it also includes a neat chart going back almost 80 years to help put the current personal savings situation into perspective.

As is typical of Kasriel fare, an ominous warning or two come along at no extra charge.

With the release of the second-quarter advance GDP data and the revisions to 2003 through 2005 data, we can update our household surplus/deficit chart. Based on first-half data, it looks as though households are on course to run yet another record deficit in 2006. To refresh your memory, we subtract from disposable personal income (after-tax income) the sum of expenditures on consumer goods/services and residential investment (value-added in housing). If households’ total expenditures are less than their after-tax income, then they are, in effect, running a surplus. This implies that they are advancing funds to other sectors – businesses, governments and/or foreign entities. If households’ total expenditures are more than their after-tax income, then they are running a deficit. This implies that they are borrowing from or selling assets to other sectors. In the first quarter of this year, households ran an annualized deficit of $566.2 billion. In the second quarter, this annualized deficit increased to $588.0 billion. Based on this first-half data, households are on course to run a 2006 deficit of $577.1 billion, which would break the 2005 deficit record of $476.7 billion (see chart below).
Assuming that households do, in fact, run a deficit for all of 2006, this would mark only the thirteenth time since 1929 that this has happened. Two years in which households ran a deficit were in 1932 and 1933 – the depths of the Great Depression. It is not hard to figure out why they might have run deficits then. With unemployment soaring, folks were selling assets and borrowing just to exist. Households again ran deficits in 1947, 1949 and 1950. Again, it is not too difficult to explain deficits in these years. During WWII, durable consumer goods and new houses were not available given that most production was being used for the war effort. And because there was not much to purchase for those working on the home-front during the war, they ran huge relative surpluses, to a large degree, in the form of war bonds. Soon after the end of WWII, with their balance sheets overflowing with assets relative to liabilities, households went on spending spree, buying houses, furniture, appliances and other consumer durables – hence the household deficits. Why households ran a deficit in 1955 is a mystery to me other than that was the year we bought the white-on-turquoise V-8 Ford.

This brings us to the “modern” era. With the exception of 2000, households have racking up large deficits starting in 1999. By the way, these deficits are not just records in absolute terms, but relative to their disposable incomes as well – e.g., 6.15% of disposable income in the first half of 2006. These “modern era” household deficits also are not that difficult to explain. Generational low nominal and real interest rates, in part engineered by the Fed, have had the effect of inflating the prices of assets – equities in the second half of the 1990s and houses in the first half of 2000s. Why should households spend less than their after-tax incomes when the value of their assets is skyrocketing? And, of course, with asset prices inflating, there is all the more collateral upon which creditors can advance loans. So long as asset inflation continues, we guess households can continue to run record deficits. We can’t wait to see how the adjustment works out when the asset-price music stops.

A concept as simple as spending less than you earn, in order to save something for the future, seems to have nearly vanished from mainstream thinking. With multiple asset bubbles now spanning a full decade, an entire nation and much of the Western world must now think that this is just the way the world works.

With the national housing mania clearly subsiding, the obvious question is, "What next?"

Another asset bubble?

Probably - the alternative is quite unpleasant just to think about.

Looking at the chart above a couple of thoughts come to mind. First, if one were to look at a similar chart for the 80 years prior to 1928, you'd probably be able to see the data for the entire period of time. In the chart above, running from 1928 to present, the dollar amounts have risen so dramatically that with the exception of the early 1940s, everything before 1960 looks like noise.

A similar chart for the 80 years prior to 1928 would look relatively level across the decades. With the exception of the Civil War, there was very little inflation during that period, the currency holding over 90 percent of its value, with little new printing of money. In the period since the formation of the Federal Reserve, the currency has lost over 90 percent of its value with money being created at rates never thought possible before.

The other item of interest in the Northern Trust graphic is that the 1980s will always be remembered for government deficits under Ronald Reagan, while American citizens still acted responsibly - continuing to save for a rainy day after generations of hard times and older, wiser relatives cautioning against excess.

Fast forward to the present day and, when combining rising asset prices with too few older and wiser relatives, American citizens have clearly lost their collective senses, opting to spend like drunken sailors with the apparent expectation that asset prices will continue to rise indefinitely.

As Mr. Kasriel comments, "We can’t wait to see how the adjustment works out when the asset-price music stops".