The Great Recession

India, Friday, May 1, 2020. It is Day 17 of the second tranche of India’s COVID-19 lockdown. There has not been a better time to acknowledge and appreciate the centrality of households to the economic universe. Households are the value bridges. They earn incomes. They spend on consumption.

Households save. Households fund the investments by the public and private sectors. They justify investments. They propel employment and self-employment.

The centrality of households to the economic universe defines both microeconomics and macroeconomics. The Great Depression was triggered by a breakdown in the monetary side of macroeconomics.

The Great Recession was triggered by major flaws in the fiscal side of macroeconomics. The Great Recession was exacerbated by a major flaw in the monetary side of macroeconomics. The Great Recession began in late 2007 and lasted until June 2009.

Relevance to India

This article will be longer than normal. First, there will be a third tranche of the COVID-19 lockdown. It has been extended to May 17, 2020. Second, the extension of the lockdown will lead to a build-up of forces that will have both monetary and fiscal repercussions.

Third, the lifting of the lockdown may lead to a surge in microeconomic activity. This could lead to a rise in short-term interest rates. Fourth, the fiscal condition of the state and the union governments could be so weak that they would have to compete with the private sector for short-term funds. There could be a flattening of India’s Treasury yield curve and the flattening of India’s economy-wide yield curve.

The United States of America (US) experienced all of the above after September 11, 2001 and all the way to September 18, 2007. The US suffered a major battering on its monetary side. The US suffered a major battering on its fiscal side. The two-headed hammer hammered households in the US for six years. Lehman Brothers fell as a consequence on September 15, 2008. There is something to September. 

The centrality of households

Households bridge value creation and value exchange. As self-employed entrepreneurs and employees they are the causes of value creation. They produce goods and services. By so doing, they then earn wages, salaries, fees and incomes.

Households then use a part of these wages, salaries, fees and incomes to buy goods and services. They support the consumption function. They also save some from their incomes and wages.

Household savings

Households save money. Many of them save. Some of them borrow. Demography and lifecycle positions determine who borrows, who saves and how much. Net-net, households are savers. The savings of households are very important.

Savings go on to fund spending and investment by the public sector. Public sector is a unified singular that refers to the union and state governments; their enterprises; and the municipal and local governments.

Savings of households go on to fund capital investments by the private sector. They are used to build homes. They are used to buy insurance. They are used to buy mutual funds. They are deposited in banks.

Insurers, mutual funds, nonbanking financial companies and banks in turn allocate our savings to the public sector and the private sector. Financial intermediaries do not sit on our money. They do not hoard our money. Why? Money does not make money.

April 26, 2020

https://www.dhirubhai.net/pulse/securing-savings-citizens-gopalan-ramachandran/

Major shifts in the attributes of savings

The Great Recession began in late 2007 and lasted until June 2009. The Great Recession was the result of major shifts in the attributes and components of savings. First, what did the US government do with the savings? (We have to plunge straight into the USA since the Great Recession was triggered by the USA.) Second, were the US borrowings short-term or long-term?

Third, did short-term and long-term interest rates move in the same direction? Fourth, did short-term and long-term interest rates move in magnitude simultaneously? Fifth, did these changes in direction and magnitude affect the households? 

Sixth, did these changes in direction and magnitude affect employment, wages and demand of households? Seventh, did these changes in direction and magnitude affect their monthly instalments on their home loans?

Eighth, did the US Federal Reserve Board assess the changing situations correctly? Finally, did the US Federal Reserve Board exacerbate the situation by raising the Federal Funds relentlessly?

Unbounded gratitude

I am most grateful to Silver Brook, Lehman Brothers, Goldman Sachs and my colleagues at BERM for the opportunity to stay close to the events that preceded the Great Recession (2003-2007), to stay close to the events as the Great Recession unfolded and progressed (2007-2009), and to stay close to the repairing and healing that followed (2009-2016). I am most grateful to the US administration under President Barack Obama for reposing trust in our analyses and scenarios. I am most grateful to the US Federal Reserve Board under Chairman Ben Bernanke for reposing trust in our analyses and scenarios.

Households primarily lend

Money does not make money. So households save. When a household saves, it can use its savings to lend as bank deposits. It can buy Treasurys, municipal bonds and corporate bonds. It can buy insurance. These are all debt.

The repayment amount and period are fixed. They are known with certainty in the case of debt. The periodic interest and coupon payment amounts – fixed and floating – are known with certainty. The redemption and its term are fixed and known with certainty. This explains why debt is also known as fixed income. Preferred stock too is fixed income, therefore.

Households can also invest in equity. Equity has no contractual redemption. There is neither magnitude nor any periodicity. Dividends are not specified. Equity is risky. Debt is not.

Households prefer debt. Households prefer to lend. Households are rational. They use debt to balance the risks associated with their education, employment, incomes and homes. When in doubt, they lend. Lending is their default setting.

In periods of high inflation, households allocate at least 80 percent of their savings to debt. In periods of mild inflation, households allocate at least 90 percent of their savings to debt. An enormously large part of household savings turns up at the banks and financial markets as debt. Fixed income is gigantic.

The borrowers

Most of the savings turns up as debt. This is a great convenience. This finds and causes an instantaneous equilibrium. There is no mismatch. Borrowers do not have to share their profits with their lenders. Borrowers have to merely pay interest and repay principal. The profits and the capital gains always belong to the borrowers.

So other households and companies borrow. When in doubt, households and companies borrow. Borrowing is their default setting. Government – the public sector – is also a borrower.

Fiscal deficit

Governments around the world run the biggest income statements and balance sheets. When they spend more than what they receive, they have a fiscal deficit.

Governments need money from the private sector to fill the deficit. They cannot issue equity. The private sector will then own the governments if governments issue equity. Ludicrous! So, they issue Treasurys. Treasury bills, Treasury notes and Treasury bonds are issued to fund the fiscal deficits.

Treasurys and terms 

Treasury bills, Treasury notes and Treasury bonds have different contractual repayment periods. Treasury bills have the shortest repayment periods, say, one year or less than one year.

Treasury bonds have the longest maturity. The US had bonds with maturities of 30 years. The maturity of the longest term bond was reduced to 20 years in February 2002. This was one of the factors that contributed to the Great Recession. It was restored to 30 years in February 2006. By then the fiscal damage had been done.

Treasury notes have intermediate maturities. At issuance, Treasury notes may have maturities between four and nine years. There are no rules for the classification. But what these maturities signify is the supply and the demand for credit for the short-term, the medium-term and the long-term.

Term structure of interest rates

The Treasury interest rates, therefore, reflect the market-clearing equilibrium rates for short-term, medium-term and long-term sovereign credit. Sovereign credit is the most reliable. Other borrowers may default. Banks, nonbanking companies and corporations may default. But within an economy, the most reliable among all borrowers is the government – the sovereign.

The Treasury interest rates for short-term, medium-term and long-term sovereign credit can be plotted with the maturity along the X-axis and the corresponding interest rate along the Y-axis. The plot of sovereign interest rates and maturities is known as the yield curve. It shows the term structure of interest rates.

The normal yield curve

This yield curve is normal because it reflects the credit needs of a growing economy. A growing economy needs more and more social and physical infrastructure. These investments will not pay off immediately. So, the borrower will have to induce lenders to lend long-term. The borrower will then have to enhance the willingness of lenders by agreeing to pay higher interest rates.

This yield curve is normal because it reflects the interest rate expectations of savers for giving away their savings for a long period of time. Households need more of their funds and the resultant liquidity when they grow older relatively. Education of children, a new home, a new car, lifetime events, vacation and upkeep through retirement will require cash. In order to part with liquidity over a longer term, savers will demand higher interest rates. For the short-term, they have their incomes.  

The inverted yield curve

This yield curve is abnormal and inverted. It reflects the credit needs of an economy in decline. A declining economy lacks the need for and the resolve to invest in more and more social and physical infrastructure. These investments are deemed to be unnecessary. So, the borrower is unwilling to induce lenders to lend at higher interest rates.

This yield curve is abnormal because savers too are somewhat in social and economic decay. They are willing to give away their savings for a long period of time. These households do not need more of their funds and the resultant liquidity when they grow older relatively. Education of children, a new home, a new car, lifetime events, vacation and upkeep through retirement are not regarded to be important.

These households are willing to part with liquidity over a longer term at lower interest rates. Money does not make money. They merely want someone to do what best is possible.   

The humped yield curve

This yield curve is a combination of the normal and the inverted yield curves. It reflects the credit needs of an economy that is in long-term decline. At the same time, it reflects the credit needs of an economy that is busy and roaring in the short-term and medium-term.

The humped yield curve reflects the healthy appetite of households for funds and liquidity in the medium-term. They are not too sanguine about the long-term. These households are willing to part with liquidity over a longer term at lower interest rates. Money does not make money. They merely want someone to do what best is possible.   

The flat yield curve

This yield curve is flat. This yield curve is out of fizz. The short-term, the medium-term and long-term interest rates are almost the same. There is something extremely important in the short-term. The demand for credit has shot up. The sovereign borrower is eager to pay very high interest rates for short-term borrowings. Is a war in need of funding? Perhaps yes!

The need for long-term credit has become subordinate to the pressing needs to fund the short-term fiscal deficit. However, the explicit demand for funding medium-term and long-term investments in social and physical infrastructure has not declined.

Consider a vital-essential-desirable (VED) analysis. Short-term borrowings are vital. Medium-term borrowings are essential. Long-term borrowings are desirable.

Savers respond to a flat yield curve by lending as much as possible in the short-term. At the same time, they lock in a known rate for their medium-term lending and long-term lending. The locking-in is a hedge.

The locking-in is a shield. It is not a spear. The magnitude of funds will be tilted significantly towards the short-term because the payoffs are high. The magnitude of funds will be tilted significantly away from medium-term lending and long-term lending because the payoffs are low.

Long-term and medium-term investments by the public sector and the private sector will correspondingly be weak. These long-term and medium investments by the public sector and the private sector are those that usually create the most employment. They create secure, long-term employment. But they are put on hold when a flat yield curve takes hold of an economy.

There are more investments in short-term working capital and in trading activities. These are not the investments that usually create the most employment. They create here-today, gone-tomorrow short-term employment. The long-term income potential of here-today, gone-tomorrow short-term employment is usually weak. Moreover, here-today, gone-tomorrow employees have volatile and unreliable incomes. The gig economy has some of these characteristics.

Inflation

We had a simple monetary model at the College of Engineering Guindy. The kitchen had a specified potential output. If there are too many tokens in circulation, there would be inflation. If there are too few tokens in circulation, there would be a shortage and a black market.

When an economy has a surge in short-term working capital and investments for trading activities, the velocity of the money in circulation would rise. This would make available more tokens for buying output. But the economy has a flat yield curve. The kitchen will continue to work at its specified potential output. The long-term investments required to raise output have not been made. Therefore, there would be inflation.

Average credit quality

The aggregate credit quality of households is a function of the quality of their incomes from self-employment and from employment. The average credit quality of households too is a function of the quality of their incomes from self-employment and from employment.

When there are more investments in short-term working capital and in trading activities, there are more here-today, gone-tomorrow jobs. Both the self-employed and the employed will gravitate towards short-term employment. That is where the jobs are. The long-term jobs have not grown. There are few long-term jobs. Moreover, their long-term incomes, salaries, wages and fees could be in jeopardy. These incomes may not be stable and strong. Hence, both the aggregate and average credit quality of households would decline. Flat yield curves undermine the credit quality of households.

Economy-wide interest rates

The interest rates paid by sovereigns are different from the interest rates paid by households and businesses. Interest rates are a function of these factors:

1 Who is the borrower?

2 What is the period of repayment?

3 Will the fiscal deficit grow? Will the deficit grow before repayment?

4 What is the inflation now? What will the change be before repayment?

5 What is the borrower’s credit quality now?

6 Will the borrower’s credit quality decline before repayment?

US interest rates are usually the most responsive to market variables and market forces. The US had entered a period of high variance after the attack on the World Trade Centre’s Twin Towers. Fiscal deficits were expected to rise. Inflation was expected to rise. Interest rates began to rise. They also became volatile.

Fixed and floating rates

When the future course of interest rates is uncertain, both borrowers and lenders would be better off by paying such rates that prevail from time to time. Floating interest rates require borrowers to pay (1) the prevailing benchmark rate plus (2) the credit spread to compensate for their lower credit quality compared, say, with the sovereign.

By contrast, fixed rates remain fixed through the term until the loan is paid off at its maturity date. The circumstances beginning with the attack on the World Trade Centre’s Twin Towers on September 11, 2001 had nudged both borrowers and lenders towards floating rates. Borrowers who borrowed to buy and build homes chose floating rates. Many of them held here-today, gone-tomorrow jobs. Their home loan (mortgage) instalments would rise along with the prevailing benchmark rate. Their home loan (mortgage) instalments would fall along with the prevailing benchmark rate.  

Bush tax cuts stoke public debt

The “Bush tax cuts” triggered a series of outcomes that raised the public debt to gross domestic product (GDP) ratio. Growth in public debt outpaced growth in GDP in 2002, 2003, 2004 and 2005. Public debt had been shrinking relative to GDP through the Clinton presidency. The Bush presidency that followed caused a reversal. Public debt grew at a fast pace in 2002, 2003 and 2004. It continued to grow thereafter, albeit at a slighter lower rate in 2005, 2006 and 2007.

Wars in Afghanistan and Iraq

Public debt grew because of the engagement in Afghanistan and the war in Iraq. Defense constituted about 16 percent of the federal outlays towards the end of the Clinton presidency. Thereafter, the defence to total outlays ratio grew steadily to over 20 percent in 2008 because of the need to fund these engagements. Public debt increased consequently.

Short-term borrowings

The Office of Debt Management of the US Department of Treasury made wrong policy choices. The Office of Debt Management had implemented a policy to bring about a decline in the average maturity of federal borrowings. Therefore, the average maturity of new debt issuances began to fall significantly after 2000. It fell precipitously from about 68 months in 2000 to about 26 months in 2002. Net-net, the US had become a short-term borrower. Moreover, the abandonment of the 30-year Treasury bond was part of this plan.

The average maturity of new Treasury stock issued was just over two years. The US government became a short-term borrower. The US government became a short-term borrower to fight what it had assumed would be a short-term war. The war in Iraq was anything but short.

The US Treasury started competing aggressively for funds in the fixed income market for shorter maturities. The competition included such issuers that were funding working capital, margin trades and assets bought for securitization. Mortgage-backed securities (MBS) were the biggest constituents in the asset-backed securities (ABS) market. 

When the policy on average maturity of debt was different, longer-term bonds constituted about 21 percent of total debt. The proportion of longer-term bonds declined to 12 percent. It remained there until 2007. The Office of Debt Management signaled its preference clearly. It preferred short-term borrowings to longer-term borrowings.

There are advantages that short-term borrowings possess. Longer-term borrowings do not possess such advantages. Bond duration is one of them. But the US Treasury bond duration went into a frontal and head-on collision with the duration of the war in Iraq.

Sharp rise in short-term interest rates

Consequently, short-term interest rates began to rise rapidly from 2003. The average three-month Treasury bill (T-bill) rate in 2003 was 1.04 per cent per annum. It rose to 1.41 per cent in 2004 and then more than doubled to 3.22 per cent in 2005. It rose further to 4.85 per cent in 2006 and stayed there until September 2007.

The average one-year T-bill rate in 2003 was 1.25 per cent per annum. It rose to 1.89 per cent in 2004 and then nearly doubled to 3.62 per cent in 2005. It rose further to 4.93 per cent in 2006 and stayed around that rate until September 2007.

Flat and then inverted yield curve

The average maturity of outstanding debt began to fall as intended by the policy of the Office of Debt Management. The average maturity of outstanding debt was about 72 months in March 2001. It declined to about 55 months in 2006. Every dollar of debt matured on average every 55 months now. Therefore, the fixed income markets inferred correctly that the US Treasury would be a frequent issuer – borrower – in order to refinance the debt repaid at maturity.

Moreover, the Office of Debt Management had signaled clearly its bias towards short-term borrowings. This bias along with the expectation of frequent issuances of debt to refinance the maturing debt further drove short-term interest rates up. The one-month T-bill rate rose to 5.27 percent per annum in November 2006. By contrast, the 30-year Treasury bond rate was 4.59 percent per annum in November 2006.

Please consider the numbers again. The cost of 30-year debt turned lower than the cost of 30-day debt. The US now had an inverted yield curve.

Subprime borrowers

Both the flat and the inverted yield curves are perversions. They goad investors to stay away from long-term investments. They persuade investors to make big, short-term investments. Long-term investments and long-term assets create long-term jobs. Short-term investments and short-term assets, by contrast, do not create long-term jobs. They usually create short-term jobs. Short-term jobs come and go. People who hold short-term jobs usually qualify as subprime borrowers.

The US’s policy mix did everything to discourage and penalise the long-term investments and the long-term assets that create the long-term jobs. The economic crisis that came to the fore as an official recession in 2007 had its causes that went a long way into the past. The crisis then burst open when it felled Lehman Brothers in September 2008. Lehman Brothers was a victim. It was not the villain.

Jobs and demand collapse

The rise in short-term interest rates began to cripple the US economy. Short-term rates rose sufficiently to match the long-term interest rates. The US now had a flat yield curve. A flat yield curve is as bad as an inverted yield curve.

A flat yield curve signals a destructive situation in an economy. It signals an expected rate of return and a demand for credit that together make lending in the short term as attractive as lending in the long term. Lenders preferred short-term assets to long-term assets since they could regain their capital and liquidity very quickly. Long-term assets such as building factories and bridges became unwise and unviable. Rebuilding US’s factories became an unintelligent choice.

The employment market crumbled. Wages began to sink. Demand for goods and services fell. This triggered a second round of falling employment and wages. Demand for goods and services fell further.

Collapse of the mortgages

But floating-rate or adjustable-rate mortgage instalments rose because the benchmark rate went up and up. Ordinary households had to face shrinking wages, the need to eat and to be clothed, and the rising mortgage instalments. They chose to default. They stopped paying the mortgage instalments. This devastated the lenders and those that owned the MBS. The US's financial industry was devastated.

Fuelled by the US Federal Reserve

The US Federal Reserve was an unwitting partner in causing the devastation. It mistook the rising short-term interest rates to be a sign of an economy that was running high on confidence, economic activity and demand. It thought it would be apt to raise the US Federal Funds rate to temper and to moderate demand.

The US Federal Reserve had overlooked the real cause: the US Treasury’s thirst for short-term funds to fight the war in Iraq. The US Federal Funds rate rose from 1 percent on June 25, 2003 to its highest of 5.25 percent on June 29, 2006. The bleeding had begun in 2005. Jobs and demand collapsed. The mortgages market collapsed. The housing market collapsed. Strangely, the 5.25 percent was held until September 18, 2007.

The Great Recession took hold during these 14 months. The US's nose was held under the water for 14 months. Then the US economy stopped breathing. The contagion spread across the world.