By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
It is generally agreed that the recent recession was a balance sheet recession. The slow recovery has been widely viewed as the result of economic agents reducing the use of leverage and otherwise repairing their balance sheets. However, attention has been focused almost exclusively on the balance sheets and behavior of the financial sector. Policy initiatives aimed directly at rebuilding household balance sheets have garnered headlines, but have had little impact. There has been little discussion of the riskiness of the asset side of the household balance sheets and the appropriate use of leverage by the household sector. Nonetheless, some commentators have suggested that households have completed the deleveraging process. They cite as evidence the decline in the ratio of debt service income from a high reached in late 2007 to levels last seen in the mid-1990s.
This post reviews changes in the household sector’s balance sheet by focusing on the use of leverage by the household sector; the ratio of assets on the balance to the reported net worth of the household sector; and the asset mix on the household sector balance sheet. It parallels analyses of capital ratios and the balance sheets of the financial sector and financial institutions.
The post raises three questions. How has the risk appetite of the household sector, as reflected in the leverage ratio and the asset mix, changed over time? Does it appear as if the household sector has completed the rebuilding of its balance sheet? What are the implications, if any, if the deleveraging of the household sector balance sheet is incomplete?
(All the data is from the Fed’s Flow of Funds Accounts)
The leverage ratio (Total Household Sector assets divided by Household Sector Net Worth-all data from the Fed Flow of Funds accounts) is very modest compared to the leverage ratios of financial institutions. However, the chart indicates that the household sector’s use of leverage increased considerably, with asset size going from about 115% of net worth to over 125% of net worth between 1999 and 2007. The household sector’s increased use of leverage is also clearly reflected in the decline in owner’s equity as percentage of Household Real Estate.
Changes in the asset mix since the 1980s are also consistent with households accepting greater risks. As the chart shows, riskier assets grew as a proportion of total assets while the proportion of the safer assets declined.
The increased use of leverage and the shift to riskier asset classes suggests that households were reaching for yield as far back as the mid 1980s. The start of this reach for yield roughly coincided with the decline in short-term rates in the mid 1980s as the need to address inflationary concerns abated.
This twenty-year reach for yield by households may have ended with losses suffered on risky assets during the crisis of 2007. The household sector’s use of leverage declined and the asset mix has shifted in favor of safe assets. However, the use of leverage and the portion of net worth in riskier assets remains elevated relative to levels of the mid-1980s and 1970s.
Has the household sector finished deleveraging and rebuilding its balance sheet? The answer is unclear. The use of leverage and the asset mix remain elevated compared to just 10 years ago. Unconventional monetary policy and near zero short-term interest rates have also clouded the picture. There are indications that unconventional policies have rekindled the reach for yield.
If unconventional policies have prevented a full balance sheet adjustment, any return to a normal policy stance will be followed by renewed deleveraging and further moves towards a less risky asset mix. This would imply that the current stance of monetary policy is not promoting a return to stability and full employment, but rather simply masking the symptoms and postponing needed adjustments in balance sheets and the real economy.