Deadlock! Total Borrowing Has Stabilized at a Mild Contraction Rate as Private Debt Reduction Stops Increasing and Government Borrowing Stays Steady

The latest Federal Reserve Flow of Funds report shows a rough continuation in Q3 2009 of the Q2 trends in borrowing. However, the big news is that it has become clearer that the private sector's negative rate of borrowing has stopped increasing and has stabilized at a level roughly opposite to the government's positive rate of borrowing.

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The above chart shows the borrowing rate as a percentage of GDP for government (federal, state and local), the private sector, and the total of the two from 2003 to Q3 2009. Last quarter it was unclear whether the rate of private sector debt reduction would keep increasing or stabilize, and for now it has stabilized (actually a slight decrease, with the trend unclear). The result is that the rate of total borrowing has stayed between -1% and -3% of GDP for the first three quarters of 2009. Some thoughts on the details:

• Steve Keen often discusses the "debt contribution to demand", i.e., borrowing adds to total demand and reducing debt subtracts from it. This stabilization in the rate of total borrowing (and its associated spending) since Q1 likely is one of the larger factors in the stabilization of GDP in Q2 and Q3 from a state of freefall (see graph on right). But see the following caveat on how this conclusion could be flawed.
  
• This data is a somewhat crude proxy for debt's contribution to demand in the sense that some government borrowing (e.g., TARP) goes to propping up balance sheets rather than supporting spending on goods and services and thus incomes. Similarly, private debt contraction is still dominated by the financial sector, the debt of which likely has a less direct correlation to GDP-related spending than does household credit, for example. Perhaps I will try separating these in a later post, but it may not be feasible to do well.
  
• One of the reasons why treasuries have no trouble finding buyers (more details in posts here and here) is that in a balance sheet recession, public debt simply fills the "hole" left by disappearing private sector debt.

Will this deadlock hold in future quarters? There are several possible scenarios that I still plan to cover in a separate post. A negative one of non-trivial probability is "double dip" recession with re-accelerating private debt reduction unaccompanied by sufficient public sector borrowing to offset the falling demand and therefore GDP. In another scenario, if the current "deadlock" were to continue as is, there would no longer be the ongoing annual increases in debt that have added to aggregate demand over recent decades (a point often emphasized by Steve Keen). This would imply a much lower level of annual growth in GDP than most expect, and is closer to the Japan outcome than the Great Depression outcome.

Evaluation of these debt trends is complicated by the huge size of both financial sector and Federal government changes in borrowing relative to other sectors:

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Mortgage debt and consumer credit are being reduced (these are typically cited symptoms of attempted deleveraging) but they are dwarfed in absolute terms by the debt reduction of the financial sector, at least so far. In relative terms (debt reduction relative to stock of existing debt of that type) the rates are slightly closer: as of Q3 around -9% for the financial sector, -4% for home mortgage debt, and -3% for consumer credit. This chart shows the annualized rates by sector:

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And here is the first chart of borrowing by sector on a longer time line, 1974 to Q3 2009:

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UPDATE: Replaced corporate debt with business debt (a broader category) in two charts.

Dividends Are Still Trending Worse Than The Great Depression

With S&P 500 earnings reporting mostly (98%) complete for Q3 2009, it's time for an update to the charts from Dividends, Earnings, and Stock Price Trends have Tracked the Great Depression.

The following chart compares the decline in twelve month trailing earnings and dividends since the stock market peaked in October 2007 to the same measures following the stock market peak in September 1929:

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Earnings have dropped more rapidly than during the Great Depression (dramatically so if you count reported rather than operating earnings), but they appear to have begun a recovery much sooner than occurred back then. Trailing 12-month dividends are still falling slightly faster than during the Great Depression, which is particularly remarkable given how much more severe deflation was then compared to now. These trends underscore that contrary to some claims, this is no crisis of confidence!

Since dividend changes tend to lag earnings changes, rising earnings could mean dividends will level out and start increasing soon (and in fact the quarterly fall in dividends from Q2 to Q3 was small). However, if earnings are being over-reported thanks to factors such as relaxed accounting rules or optimistic loan loss assumptions, dividends should ultimately reveal the truth about underlying cash flows.

And while we should all hope that this recovery can be sustained, there is a significant probability (details of which I hope to discuss in a separate post) that this is a temporary upturn in a longer term depression. A renewed fall in GDP, persistent unemployment, and intensifying deflationary pressures would not be good news for any fledgling recovery in earnings and dividends.

Here is a chart comparing the dividend yield today with the Great Depression trend. Yields are much lower today and are trending down again despite the significant upward yield trend back then. So is this a genuine early economic recovery, or a sign that the modern stock market tends to be a capital-gain seeking momentum machine with little regard for underlying fundamentals? Yes, interest rates are low, but they were back then too, and David Rosenberg suggests most current corporate bond yields are a lot more attractive than yields of the same companies' stocks.

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The next chart compares price/earnings ratios earnings during the Great Depression with today using reported earnings. There is no comparison.

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It is clear that the market has accepted Wall Street's encouragement to ignore reported earnings when valuing stocks, so here is the same price/earnings chart using operating earnings (for the recent trend — the measure had not been invented back then):

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The P/E ratio based on operating earnings has soared above 25 just as it did at a later stage during the Great Depression. I just wish I had more confidence that this was the start of an earlier sustainable recovery rather than a sign of the irrationality of markets and reckless myopia.

Note: All of these charts use Robert Shiller's monthly stock data (with a single representative stock price for each month), not daily prices.