Thursday, February 19, 2015

Housing Tax Policy, A Series: Part 9 - Credit and Currency

Considering the rhetoric surrounding the economy over the past 20 years or so, I am surprised at how normal the trends look in monetary and credit growth.  I am not a monetary economist, so please comment if I make any important errors here.

I am using Loans and Leases in Bank Credit and Currency as my points of reference here.  I realize that these aren't necessarily typical for this kind of discussion, but I think they more or less convey the information I am looking for.  First, here is a long-term graph of the combined total of currency and credit.  Since WW II, the growth of this quantity has followed fairly tightly with an 8% annual rate, falling slightly below trend in low inflation eras and growing slightly above trend in high inflation eras.

The second graph shows rent (both owner and tenant) as a percentage of GDP since 1929.  I think what we are seeing here is that pre-WW II, less than 50% of households owned their homes.  And, those who did own real estate mostly held it in equity.  This was a cash-heavy economy.  In 1947, there were about equal quantities of currency and loans & leases in bank credit!

I am not showing the graph here, but after WW II, there was a tremendous shift in the housing economy.  Households gained access to mortgage credit, and many of them became home owners.  Average Loan to Value moved from less than 30% even in 1952 to 45% in the mid-1960s.  And, homeownership rates rose from less than 50% to the mid 60%'s over that time frame.

So, if we look at bank credit and currency, we find that during this period, currency levels were flat for 15 years.  All of the growth came from expanding bank credit.

But, after that expansion ended, bank credit assumed a less steep trend.  This graph from 1974 to present shows both currency and bank credit growing together at a very similar trend of about 2% per quarter.  What is surprising is that, despite all the loud protestations about loose money and pretend growth, there was no movement above trend in either of these quantities in the 1990's and early 2000's.  It looks likely to me that the slight rise in bank credit after 2006 was a reaction to the sharp curtailment of currency.  Households had managed the leverage in their portfolios through the housing boom, so that until the Fed gave the economy one last push off the cliff in 2008 such that even credit markets seized up, households were making up for the currency shortage by tapping their available credit.  This ended in late 2008.

I think there are several points of confusion that lead to misinterpretations, several of which I have described before.

1) This strange insistence we have of speaking of monetary policy in terms of interest rate levels.

2) In the late 1990's and early 2000's, there was a large, sustained increase in residential investment, and there was also a rise in home values (which I attribute mostly to low long term interest rates and increasing tax benefits to homeowners).  As I have discussed before, because of the way we transact and think about real estate, this causes real estate to increase in nominal value in ways that other assets don't.  This is also an asset class that more households tend to follow and be familiar with.  Also, people tend to confuse the nominal value of homes with the cost of housing.  But, as shown in the second graph above, total consumption of housing was not increasing sharply during this period.  And, more than is commonly noted, much of the rise in home values was in equity.  Loan to value levels, in aggregate, were pretty steady over this time, and below 50%.  The only way that higher nominal values of existing real estate translate into higher nominal economic consumption is through access to credit.  If households had seen home values rise another 100%, but didn't take out any more mortgages, then nominal expenditures would not have been affected.  Now, it is true that most of the growth in bank credit at the time was in mortgages, but it wasn't enough to push credit above long term trend growth.  As seen in the graph above, much of the growth in mortgage credit was countered by a relative decline in industrial credit.

Securitized mortgages not held by banks would also not lead to monetary expansion.

(As an aside, note again in the Fred graph how real estate credit seems to line up with the 1986 and 1996 tax changes.  Also, note how there was no relative growth in mortgage levels associated with the additional 2.5% of homeowners between 1994 and 1999.  I do think that, these additional home owning households tended to be more highly leveraged than average.  But, as I mentioned in the comments of the previous post, these would have been much smaller dollar amounts than average, so even by 1999, when half of the total new growth in homeownership would have already been on the books, it probably added less than 1% to the total mortgage level.  That is simply swamped by the other factors that we can see in the graph are moving mortgage levels at a much greater scale.  This simply couldn't have scaled up to a quadrupling in mortgage credit and a tripling in home prices.  The scale is too small by orders of magnitude.  The anecdotal evidence that feeds the notion of the importance of the subprime mortgage market simply doesn't account for the problem of scale.)

3) Corporations massively deleveraged between 1980 and the present.  Most growth in corporate values has been in equity.  And, as with real estate, this should lead to a need for more currency, since aggregate added enterprise value among corporations has not led to growth in bank deposits.

4) Domestic corporate valuations have not grown as strongly as it seems because of our conventions for tracking their values.  First, since the early 1980's, there has been a significant change in capital income distribution, from dividends to buybacks.  Both methods have the same effect on the capital base.  But, dividends cause stock index values, like the S&P 500 index, to decline, whereas buybacks have no effect on the index level.  For the past 30 years, stock market indexes have been overstating growth in corporate capital by about 2% per year.  This is a large difference over time.  There is growth in the capital base outside of the indexes, from entrepreneurial activity.  But, the new tech. firms that have been replacing old capital tend to have low debt levels and hold a lot of cash.  This transition from old firms that required a lot of physical capital and utilized a lot of debt to new firms that have little debt and a lot of cash is deflationary, given a stationary currency level.

Secondly, much of the growth in corporate profits and valuations is related to foreign operations, and much of the profit from those operations is being reinvested abroad.  This also causes stock valuation indicators to overstate the nominal level of domestic activity, to the casual observer.


Total credit + currency at the end of 2007 was $7.5 trillion.  If it had continued to grow at 8% per year, it would be up to $12.8 trillion.  Instead it's at $9.1 trillion.  That is nearly 30% below the 70 year trend!  This should be extremely deflationary.  It suggests, for starters, that if the mortgage credit market remains stuck, the entire quantity of excess reserves could be released as currency without any inflationary effects.  I don't think that is actually the case.  But the reason it isn't the case isn't because of the currency itself.  It's because the currency would probably mostly become equity in real estate, and eventually the added equity would deleverage households enough that mortgages would start to grow, too.  But, that is an assumption.  If mortgages are mostly stagnant because of an impasse between banks and regulators, then I don't think the new currency would be inflationary.

So, why aren't we experiencing extreme deflation right now?  I think the reason is because this has mostly played out through the real estate market.  So, first, there are millions of homes that haven't been built over the past decade.  The housing stock is probably something like 5% below where we might have expected it to be.  That's about 0.5% of real GDP that is just missing.  Most of the rest comes through returns to homeowners.  Most of that $3.7 trillion in missing money would have been used to bid houses up to their intrinsic values.  Because that credit went missing, houses are below their intrinsic values.  But, landlords and homeowners are still earning the same rents that they would be earning if the homes were correctly priced.  So, unless you need to sell your home, the lost liquidity is not visible to you.  In the meantime, institutional investors are buying like crazy to get those excess returns.  But, owner-occupier households have been so dominant in the single family residence category for so long - because we used to facilitate mortgage funding - that the organizational foundation for single family home rentals can only grow so quickly.

So, why hasn't this been the case in previous recessions?  Look at that first graph.  We haven't had a liquidity crisis this bad since the Great Depression.  And, since real estate was mostly owned with very little use of credit, the decline in currency filtered through the economy differently than it is today.  (Added: The recession of 1990 was associated with a brief deviation from trend that amounted to a permanent decline of nearly 20% in currency and credit.  But, inflation was running at 5% when that recession began.  And real interest rates were high and risk premiums were low.  Yet, with all that going for us, in real terms, home prices declined by 25% by 1996!  And nominal interest rates fell sharply - because not only are interest rates a terrible way to judge monetary policy, but to the extent that they are, low long term interest rates are a sign of tight money, not loose!)


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  2. Kevin,

    Where did you get your Loans & Leases data? I ask because it really matters a lot what thing we're looking at. Commercial & Industrial bank loans, for example, are not smoothly increasing, but total bond debt is, simply because the size of firms is increasing.


    1. Thanks for the input, Jeff. I might have a conceptual error here. I am using the Loans & Leases series from the Fed's H8 report, which includes C&I Loans, Real Estate, and Consumer Loans. My point in using it here is as a proxy for monetary expansion through bank credit. Bond transactions between corporations and non-bank investors would not have the same effect on the money supply. Correct? I am certainly not an expert in this area, so input is welcome.

    2. Right, I see what you're getting at, and it would be very interesting to separate C&I from consumer loans. Never mind if you have done this elsewhere, since I'm still looking through your posts.