US expansion still making sober use of credit

Report sent March 17, 2019

Last week, the Flow of Funds data were updated through the fourth quarter.   It now seems as though a very gentle “deleveraging” has resumed, following an extremely tepid move to releveraging between roughly the middle of 2015 and the middle of 2018.

There is occasionally some confusion about the implications of deleveraging.   A contractionary shock to either credit supply or the private sector’s appetite for new borrowing can be quite destabilizing. And this is particularly the case when the flow of aggregate demand has been dependent on rapid credit expansion, as the Global Financial Crisis demonstrated quite clearly.   However, by the time the shock is realized into slower credit growth (or contraction) the damage to the economy is already done.

Closely related, it is actually quite constructive for aggregate demand growth and the stability of the expansion when nominal spending growth is not particularly dependent on credit, that is, when there is a deleveraging trend in place.  Businesses whose revenue stream is directly linked to new borrowing will obviously have a different perspective on this. But from the perspective of macro stability, the observation that credit growth is running less quickly than demand growth is favorable.

Some of the workhorse mechanics behind this principle were set out by Jason Benderly of Applied Global Macro Research, as I discuss briefly in this report.  The force of Jason’s argument is actually reinforced by a separate issue relating to r vs g, which was developed by (perhaps among others) JW Mason.  The two perspectives working together explain why releveraging has not developed, even though we are now ten years into an economic expansion.  They also explain why the lack of releveraging is a positive, at least taken in isolation, and at the frequency of the business cycle.

Within this general trend toward deleveraging – or a lack of releveraging – the household sectors stands out in particular as pristine and not reliant on excessive credit growth. The corporate sector presents a more complicated, less clear-cut, and trickier situation. At some point financial engineering may get disciplined by the corporate debt market. Again, though, from an economic stability perspective, it is encouraging to see that the corporate sector also remains in healthy underlying financial surplus.  That is capital spending is actually fairly disciplined relative to internal funds.

Obviously, this does not mean that recession is implausible. With the Fed now trying to contain demand growth roughly to potential, the risks of an accident virtually have to be higher than they were. But this deleveraging theme fits into argument against nearby recession as the base case.