Friday, March 10, 2006

U.S. Economic Imbalances Worsens

Yesterday two key reports on the imbalances of the U.S. economy were published, on the trade deficit and the "Flow of Funds" report.

The trade deficit increased to a new record high of $68.5 billion in January. That was a lot higher than the average estimate of economic analysts, but lower than the $70 billion I thought it would rise to. The main reason why the deficit came in lower than I expected was smaller than expected surpluses in Canada and Germany. But even so, the deficit is extremely high and still on an upward trend.

The reason why the trade deficit rose can be found in the "Flow of Funds" report released later that day by the Federal Reserve.

It showed that household debt rose 2.76% from the upwardly revised level of $11187.9 billion in the third quarter (previously published as $11000.3 billion, a upward revision that were partially -but only partially- cancelled out by a $148.2 billion downward revision of corporate debt) to $11496.6 billion. Household debt is now at a record 124.3% of disposable income, or 90.1% of GDP. Total private sector debt rose to a record 155.4% of GDP. When Alan Greenspan became Fed chief private sector debt was only 120% of GDP, with household debt being at 77% of disposable income or 56% of GDP. Mortgage debt alone, at 94% of disposable income or 68% of GDP is now much higher relative to income than all forms of household debt were in 1987.

The optimistic spin being made by some economists like Mike Mandel of Business Week is that this massive debt increase is more than offset by
rising asset values, taking household net worth (including net assets of non-profit organizations) to a new record high of $52.1 trillion.

It is indeed true that if these asset price increases were sustainable, then the rising debt level wouldn't be a problem. But as asset values are ultimately derived from national income, then rising asset prices in excess of national income growth is not sustainable. And as we saw in 2000-02, asset prices can fall. But debts will not fall along with the asset values. And with debts reaching a record 18.6% of assets (By comparison the debt/asset ratio was 14.5% in 1987, and only 14% as late as 1999 ) , leverage is higher than ever. Something which is particularly true in the housing sector, where mortgage debt relative to housing values have risen to 44% from 33% in 1987, despite record high housing valuations.

Moreover, Mandel's derivation of "real net worth", fails to take the lost purchasing power from higher prices of houses and other assets into account.


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