US Now vs Japan 1990s - Part II, Real Estate

This week's river-drift of data from the US is all about the state of the property market – so it's time to post the second part of how the US's deleveraging cycle looks fundamentally different from that of Japan in the 1990s.

It's no longer breaking news to anyone that the US has embarked on a private sector deleveraging which constrains its business cycle, and from there it's easy to conclude, as some very smart analysts have, that the US is at the end of its debt super-cycle. (Though what's a debt super-cycle anyway? Is it just a demographic cycle in heavy disguise? Discuss later.) And from there it is but a short step to seeing the US now in much the same state as Japan in its immediate post-bubble years.

But I think that's a step too far. Debt deleveragings come in at least three different flavours: corporate debt de-leveraging, household debt deleveraging, and government debt deleveraging. These must necessarily play out in different ways. Unless the bond markets have you by the throat (a la Eurozone currently) policy choices define the scope and pace of government debt deleveraging. With politicians calling the shots, this means they are usually achieved without noticeable pain, via growth outstripping the pace of government spending. Quite often, countries don't even notice they're doing it.

Deleveraging led by corporate deleveraging is far more painful, particularly in capital-intensive economies. As long as it goes on, corporate deleveraging will necessarily depress returns on capital, and thus delay the arrival of a new business/investment cycle. That isn't the whole of the story of Japan's lost decade(s), but it is probably the single most important plotline.

Thankfully, as we've seen, the US's deleveraging isn't driven by the corporate sector, but by the household sector, and, associated, by the financial sector which abetted the build-up of debt in the first place.

I've run this chart many times, and doubtless I'll be updating it next week when the US's latest flow of fund tables are published. It makes two simple points: first that there was a dramatic change in financial behaviour by the household sector starting in 2001, when the traditional desire to build up net deposits with credit markets reversed. Second, that this behaviour reversed dramatically in 3Q07, since when the US household sector repaid over US$1.5 trillion in net debt. During the same period, the banking system's loan to deposit ratio has fallen from a peak of 102% to 82% now. That's the lowest rate of bank leverage since the mid-1980s.

Now the key driver of household debt deleveraging (and the associated bank deleveraging) is the housing market, since mortgage debt is the biggest single financial liability any household is ever likely to take on. (This is also why the waxing and waning of this 'debt super-cycle' may turn out to be inextricably linked to the underlying demographics.)

So it is to the housing market that we must turn for evidence of the state of the cycle, and comparisons between the US now and Japan in the early 1990s. The next chart looks at the growth in volume of housing construction starts in the period before the financial crashes of 1Q90 (for Japan), and 4Q08 (for the US).  

The experience of Japan then and the US now are utterly different. In Japan's case, the realization that the housing market was in trouble really didn't become active until a year before the crash (hardly surprising this – in Japan, the leverage was concentrated in the corporate sector). In the US, the housing market had been in stall for fully 12 quarters before the financial collapse arrived. Consequently, whilst in Japan, the bursting of the housing bubble was met with a disbelief which died very long and very hard (I remember meeting Japanese property investors in Hong Kong in the early 1990s looking for a market 'like Japan, where prices never go down'), there's no such illusion in the US now.

Both countries discovered culturally specific ways to delay dealing with the consequences to the financial system of bad mortgage assets; the Japanese by a long period of extended government and bank collusion in denial; the US by discovering a Gordian knot of legal and regulatory malfeasance which at one point threatened to strip away any clear concept of ownership or liability.

Nevertheless, after five years during which housing construction has fallen by around 75% in volume, and – with a lag of a year – prices have fallen by around 25%, the main feature of the housing market is depressed stability. New home construction has been running around 600,000 since the beginning of 2009, sales of new homes have been similarly static (give or take the a-seasonal impact of housing-related tax breaks arriving and departing) during that time, as have the prices paid for them.

Most crucially, it no longer matters very much: residential housing investment has fallen to just 2.5% of GDP, the banks have deleveraged, and so has the household sector. The housing sector's already done the damage it's going to do. If it ever picks up, it will be a pleasant surprise at the margins. If it doesn't – well, I guess we'll have to look to the corporate investment as the key cyclical driver (it's about 10.4% of GDP).

Which leads to a final point: there's absolutely nothing incompatible between household debt-deleveraging and sustained consumption growth, just as there's nothing incompatible between government debt-deleveraging and GDP growth. In terms of the maths, there's likely to be a big jolt on consumption when households change from adding debt to paying it down, with an echo heard in Year Two's data. By Year Three, the other normal cyclical factors return to dominate patterns of marginal consumption – ie, the state of the investment cycle, and the impact that has on labour market conditions.

In short, the US right now doesn't really look much like Japan in the early 1990s.