Ben S Bernanke: Balance sheets and the recovery
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the 41st Annual Winter Institute, St. Cloud State University, St. Cloud, Minnesota, 21
February 2003.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
Economic growth and prosperity are created primarily by what economists call "real" factors - the
productivity of the workforce, the quantity and quality of the capital stock, the availability of land and
natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and
managers. But extensive practical experience as well as much formal research has highlighted the
crucial supporting role that financial factors play in the economy. An entrepreneur with a great new
idea for building a better mousetrap or curing the common cold needs access to financial capital -
provided, for example, by a bank or a venture capitalist - to transform that idea into a profitable
commercial enterprise. To expand and modernize their plants and increase their staffs, most firms
must turn to bond markets, stock markets, or banks to obtain the necessary financial resources. And
without a well-functioning mortgage market, most families would not be able to buy homes,
undercutting one of our most vital industries. In short, healthy financial conditions help a country to
realize its full economic potential. For this reason, one of the first priorities of developing nations is
often to establish a modern, well-functioning financial system.
Just as a strong financial system promotes growth, adverse financial conditions - for example, a weak
banking system grappling with nonperforming loans and insufficient capital, or firms and households
whose creditworthiness has eroded because of high leverage, poor income prospects, and assets of
declining value - may prevent an economy from realizing its potential. A striking contemporary case is
that of Japan, where the financial problems of banks and corporations have contributed substantially
to a decade of subpar growth. Likewise, the severity of the Great Depression of the 1930s was greatly
increased by the near-collapse of banking and financial systems in a number of major countries,
including the United States.
Changes in financial conditions may also play a prominent role in the contraction and recovery phases
of business cycles, although the specific aspects of the financial system most affected vary from cycle
to cycle.1 For example, recovery from the 1990-91 recession was delayed by the "financial headwinds"
arising from regional shortages of bank capital (Bernanke and Lown, 1991). From a financial
perspective, the most striking developments of the most recent recession have been sharp declines in
equity values (particularly in the high-tech sector) and a series of large, high-profile corporate
bankruptcies. Other financial developments have been the subject of comment, however, including the
rise in various indicators of financial stress among both consumer and corporate borrowers.
Like many others, we at the Federal Reserve are trying to peer into the future and divine the shape of
the U.S. economic recovery in 2003 and beyond. In doing so, we have necessarily had to ask: Will
financial conditions - as reflected in, for example, the balance sheets and income statements of
households, firms, and financial intermediaries - support a strong recovery? Or will financial problems
in one or more sectors restrain spending and economic growth? These are the questions I will address
today. To anticipate, I will conclude that - although areas of financial weakness are certainly present in
the economy, as in every recession - the financial problems that currently exist do not seem sufficient
to prevent an increasingly robust economic recovery during this year and next. In particular,
households and the banking system seem to be in good financial condition for this stage of the
business cycle. The story for firms is more mixed, with some companies and sectors under significant
financial pressure. However, as I will discuss, many firms have taken advantage of low interest rates
to restructure their balance sheets and most seem financially capable of undertaking new capital
investment and of ramping up hiring.
I will talk briefly about each of these vital sectors: households, firms, and banks. Before continuing,
however, I should remind you that the views I express today are mine alone and do not necessarily
represent the opinions of my colleagues at the Federal Reserve System or on the Federal Open
Market Committee.
The financial health of households
Let's start our financial checkup of the economy with the critical household, or consumer, sector.
Consumer spending accounts for more than two-thirds of gross domestic product (GDP), and
residential investment - the construction of new homes - makes up another 4 percent or so of GDP. In
2002, with firms extremely reluctant to make new capital investments or build inventories, strong
consumer spending was instrumental in supporting the early stages of the recovery. However,
concerns have been raised about the ability of households to continue "shouldering the load," so to
speak. Are consumers overburdened, financially speaking? Or do they have the capacity to continue
to keep spending at a reasonable pace?
According to virtually all studies of household expenditure, two principal factors affect the consumer's
ability and willingness to spend. The first factor is real (that is, inflation-adjusted) after-tax income, also
called real disposable income, and the second is real wealth. Taken together, disposable income (both
current and expected) and wealth summarize the household's lifetime command over resources and
thus are major determinants of willingness to spend.
A principal reason for the consumer's resilience during the past two years has been continued healthy
growth in real disposable income. Real disposable income typically declines at some point during a
recession, and indeed the National Bureau of Economic Research's business cycle dating committee
treats a period of decline in real income as a primary indicator that a recession has begun. In this
latest downturn, however, unlike most recessions, real income never did stop growing; instead it rose
by 1.8 percent in 2001 and by a surprisingly strong 4.5 percent in 2002. These increases in real
income were made possible to a significant extent by tax cuts and increased transfer payments,
although increases in real wages played a role as well. Expectations for future increases in real
disposable income also appear to be relatively optimistic, perhaps reflecting the recent strong
performance of labor productivity. For example, the most recent Blue Chip consensus forecast is for
real disposable income to grow 3.1 percent in 2003 and 3.5 percent in 2004 and to average growth of
3.2 percent per year over the 2004-13 period. For comparison, the average growth in real disposable
income between 1993 and 2000 was 3.4 percent. In short, there is a reasonable chance that, in terms
of real income growth, the next decade should be as good for households as the nineties were.
Although income and income prospects are positive factors for household spending, the behavior of
wealth - that is, household assets minus household liabilities - has been more of a mixed bag.
Between 1980 and 1994, the ratio of household wealth to household disposable income remained
roughly stable, hovering between about 4.3 and 5.0. Then, beginning in 1994, the ratio of household
wealth to income surged, peaking at more than 6.0 in 2000. In the past three years or so, however, the
ratio of wealth to income has fallen back to about the 1994 level, at just under 5.0. As you might
guess, almost all of this large swing is attributable to the recent boom and bust in the stock market.
The aggregate value of U.S. equities, which approximately equaled household disposable income at
the end of 1994, reached 2.5 times disposable income at the beginning of 2000, but then it fell back to
1.3 times disposable income by the end of 2002. Most of us have heard the wry joke that our 401(k)s
are now 201(k)s! Although in dollar terms, stockholdings remain concentrated in the upper income
brackets, the pain of falling stock prices during the past three years has been widely shared: More
than half of all U.S. households now own at least some equities, either directly or indirectly through
such vehicles as mutual funds, pension plans, variable annuities, and personal trusts (Aizcorbe,
Kennickell, and Moore, 2003).
For some households at least, losses in stock portfolios have been mitigated by significant increases
in the value of residential real estate. These rises in house prices have led some to worry about the
possibility of a "bubble" in housing prices and the associated risks of further losses in household
wealth, should this putative bubble pop. Let me digress for a moment to address this issue. Although
bubbles in any asset are notoriously hard to spot in advance (if they were obvious to the naked eye,
they would not arise in the first place), in my judgment there is today little evidence of serious or
systematic overvaluation in the U.S. residential housing market. In particular, for the nation as a whole,
the rise in house prices appears to have closely tracked economic fundamentals - including rising
household incomes, high rates of household formation, and historically low mortgage interest rates.
Also, the U.S. housing market is not a single market but many markets that are highly dispersed
geographically across dozens of disparate standard metropolitan statistical areas, or SMSAs.
Experience suggests that house prices across SMSAs are rather imperfectly correlated and that price
reversals, when they occur, are typically localized. Moreover, the ratio of the value of mortgage loans
outstanding to home values in the aggregate has been roughly constant over the past few years, and
most homeowners have substantial equity in their homes; thus even if moderate declines in house
prices were to occur, they would not impose financial hardship on the great majority of households.
Returning to the main thread of the discussion, I now address two related questions: First, how has the
overall decline in wealth associated with the fall in stock prices affected consumer spending thus far,
and second, how is it likely to affect spending in the next year or so? Statistical analyses by
economists have found that a one-dollar change in wealth leads to a permanent change in
consumption spending, in the same direction, of about three to five cents - the so-called "wealth
effect." The full effect of a major shift in wealth on consumption spending appears to take place over a
period of one to three years. Fed staff estimates are that wealth effects held back the growth in
consumption spending by about 1-1/2 percentage points last year, relative to what it would have been
otherwise. Assuming no further major declines in the ratio of wealth to income, this drag should
diminish a bit, to about 1 percent this year and 1⁄2 percent next year. In short, the largest part of the
negative wealth effect created by the fall in stock prices is probably behind us.
One might wish to dig deeper, of course. For example, disaggregating wealth into asset and liability
components is sometimes useful. Breaking out household liabilities reveals that aggregate household
debt and the debt service burden - that is, interest on debt measured relative to disposable income -
rose to fairly high levels in recent years. For example, the ratio of debt service to disposable income
peaked at 14.4 percent in the fourth quarter of 2001, although it fell somewhat in 2002 as disposable
income rose and interest rates declined. A few other indicators of financial pressures have also risen.
For example, personal bankruptcies rose 5 percent between 2001 and 2002 to hit a new high, and
have continued to be elevated. Do these indicators imply that the consumer is financially
overextended? Broadly, I think the answer is "no." In this regard, two items are worth stressing: first,
the composition of the recent surge in consumer debt and, second, the role of the recent growth of the
subprime credit market.
Regarding the composition of debt, a key fact is that most of the recent expansion in consumer debt
has been in the form of mortgage debt. Indeed, in 2002 new mortgage debt accounted for close to
90 percent of the overall growth in household debt. This recent growth in mortgage debt continues a
marked trend. Between 1992 and 2002, mortgage debt of households rose from 59 percent of
aggregate disposable income to 74 percent of disposable income.
Why has mortgage debt risen by so much in the past decade? One very positive factor is the secular
increase in U.S. homeownership rates.2 Because of rising incomes, increased rates of family
formation, and the expansion of so-called subprime mortgage lending, more people have chosen to
buy homes rather than to rent, increasing the value of mortgages outstanding. A second factor is
favorable tax treatment: The 1986 tax reform act, which retained the tax-deductible status of mortgage
interest but eliminated it for other types of loans, spurred a substitution of mortgage debt for consumer
credit (for example, through the popularization of home equity lines of credit). Finally, most recently,
mortgage debt has been powerfully boosted by the low mortgage interest rates available in the past
couple of years. These low rates have stimulated record amounts of new home construction, which
has not only permitted a growing number of Americans the opportunity for home ownership but has
played a vital role in maintaining aggregate demand throughout the recession and recovery - not only
in the construction industry but in ancillary industries such as home furnishings.
As you may know, low mortgage rates have not only stimulated home construction but have also
induced an enormous wave of refinancing of existing mortgages. According to a recent article in the
Federal Reserve Bulletin (Canner, Dynan, and Passmore, 2002), 10 percent of U.S. households
surveyed in the first half of 2002 reported having refinanced a home mortgage since the beginning of
2001. Refinancing has allowed homeowners both to take advantage of lower rates to reduce their
monthly payments and, in many cases, to "extract" some of the built-up equity in their homes.
According to the Fed study, the average amount of home equity extracted in cash-out transactions in
2001 and early 2002 was $27,000. Refinancing activity surged further in the second half of 2002:
According to one set of Federal Reserve staff estimates, mortgage refinancings totaled $400 billion in
the third quarter of 2002 and more than $550 billion in the fourth quarter of 2002, after averaging
$325 billion (quarterly rate) over the preceding six quarters.
From a macroeconomic point of view the refinancing phenomenon has very likely been a supportive
factor. The precise effect is difficult to identify, since we cannot know for sure how much of the
spending financed by equity cash-outs might have taken place anyway. Fairly generous assumptions
about the propensity of households to devote equity cash-outs to new spending suggest that
refinancings may have boosted annualized real consumption growth between 1⁄4 and 1⁄2 percentage
point in the second half of 2002, the period of maximum impact. A fairly substantial gap still remains
between the current level of mortgage interest rates and the average level of interest on the
outstanding stock of mortgages, suggesting that refinancings should continue at a brisk pace in the
early part of this year. As refinancings slow later this year, however, they will create a slight drag on
consumption growth relative to 2002.
An important aspect of the surge in mortgage refinancings is that, on the whole, they have probably
improved rather than worsened the average financial condition of the household sector. Notably, a
substantial portion of equity extraction, probably about 25 percent, has been used to pay down more
expensive, nondeductible consumer credit (such as credit card debt or auto loans), with additional
funds used to make purchases (such as cars or tuition) that would otherwise have been financed by
more expensive and less tax-favored credit. In short, the consumer has taken advantage of an
unusual opportunity to do some balance sheet restructuring. This restructuring has not come at the
cost of a dangerous increase in leverage. As already noted, loan-to-value ratios for home mortgages
have barely changed in recent years. Moreover, analysis by members of the Federal Reserve staff
suggests that the great bulk of cashed-out equity has been taken out by older, long-tenure
homeowners who have gone into the transaction with high levels of home equity (often 100 percent
equity) and have retained substantial equity after the transaction. In summary, a deeper analysis
shows that much of the apparent recent increase in the household sector's debt burden reflects a
combination of increased home ownership, partial liquidation of the home equity of long-tenure
households, and balance-sheet restructuring by households toward a more tax-efficient and
collateralized form of debt, that is, mortgage debt. For many families this restructuring has resulted in
lower leverage and payments, rather than the reverse. I conclude, therefore, that the rise in consumer
debt for the most part does not presage financial problems in the household sector.
What then about the rise in bankruptcy rates and similar indicators? Bankruptcy rates are hard to
forecast, as they vary over time with changes in law and financial practice; moreover, they themselves
do not tend to forecast broad economic conditions very well. One partial explanation for their recent
increase, as I intimated earlier, may be the expansion earlier in the decade of the so-called subprime
lending market, in which lenders sought to make loans to households whose credit histories excluded
them from the mainstream market. Although some legitimate concerns have been raised about lending
abuses in this market, overall the expansion of the subprime market is a positive development,
opening up as it does new opportunities for borrowers previously excluded from credit markets. Not
unexpectedly, however, lenders, borrowers, and regulators have faced a significant learning curve as
this market has developed, and perhaps we should not be surprised that some of the loans made in
this market in a period of strong economic growth have become distressed in a period of recession
and rising unemployment. Moreover, default rates tend to increase with loan age, so that even absent
a macroeconomic downturn it would not be entirely unexpected to see a rise in defaults as the
subprime loans made in the nineties begin to age. We hope that, as the market evolves and becomes
more sophisticated, its sensitivity to cyclical fluctuations will decline, which - among other things -
should reduce the cost of credit to subprime borrowers.
Broadly speaking, the bottom line is that the consumer seems in pretty good shape for this stage of
the cycle. As I indicated, I expect that household spending will continue into 2003 and 2004 at a pace
consistent with a strengthening recovery. Probably the main risk to this forecast is not the state of
household balance sheets but the state of the labor market, as a significant increase in unemployment
might lead consumers to retrench. At this point, however, the labor market, while not nearly as robust
as we would wish, appears at least to be stable.
The financial health of firms
If consumers have done their part and more for the economic recovery, so far the dog that hasn't
barked is the business sector. True, firms have distinguished themselves in at least one way: The
increases in productivity we have seen in the nonfarm business sector over the past two years have
been truly remarkable, particularly in light of the fact that productivity growth is typically weak during
cyclical declines. Clearly, managers have dedicated themselves to producing more with less and to
raising profits by cutting costs.
In another, critical sense, however, the business sector has not yet played its normal role in the
recovery. Atypically for the post-World War II period, the current recession began as a slowdown in the
business sector, particularly in capital investment, rather than as a retrenchment in household
spending. Now, two years after the recession began, firms continue to be highly reluctant to expand
operations - either by investing in new capital equipment or by adding to their workforces. What's
going on?
Let's start by discussing the fundamentals underlying firms' investment and hiring, and then ask
whether financial conditions can support the fundamentals. As I speak, the enormous uncertainty
regarding the situation in Iraq and other foreign hot spots still continues to cast a heavy pall on firms'
planning for the future. That uncertainty will have to be significantly reduced, I think, before we can get
a real sense of the strength of the underlying economic forces driving the nascent recovery. However,
a number of factors suggest that investment and hiring should pick up in the months ahead. For some
time now, the business sector has been meeting a growing final demand without adding capital or
employees. Presumably, businesses cannot indefinitely squeeze increasing productivity out of fixed
resources and eventually will need to invest and add workers to meet the demand for their output.
Moreover, much of the investment done during the 1990s boom was in relatively short-lived
equipment, which may soon need replacement. Inventories are also currently lean and will likely need
replenishment if final demand grows as forecast.
Other fundamental factors support the idea that investment will gradually increase this year. The cost
of capital remains low for most firms, reflecting the attractive long-term interest rates for borrowers with
good prospects and the tax benefits to investing in equipment created by the partial expensing
provision. Cash flows are improving. Ongoing technological changes imply that adding the newest
generation of equipment should make possible still greater gains in productivity. Indeed, aggregate
investment is currently well below what standard econometric models would predict, an effect that I
attribute primarily to an unusually high level of uncertainty about geopolitical events and, to a lesser
extent, about the likely near-term evolution of the economy. If that interpretation is correct, then, as
uncertainty diminishes, investment should increase.
One argument against this relatively upbeat assessment is the view that a "capital overhang" remains
from the high investment rates of the late 1990s. I will leave a fuller discussion of the putative
overhang problem to another time, saying here only that I believe that whatever significant overhang
remains is localized in a few industries - possible examples being telecommunications, commercial
aircraft, and commercial structures - and is probably not a major negative factor for investment in the
broader economy at this juncture.
Accepting provisionally that (pending some reduction in uncertainty) economic fundamentals support a
near-term expansion of capital investment and hiring, we now ask: Do firms have the financial capacity
to undertake substantial expansion? From a financial perspective, the nonfinancial corporate sector
presents a mixed picture, one distinctly weaker than that of the household sector. We have already
mentioned the poor performance of the stock market. Corporate profitability has recently shown some
signs of recovery; however, at about 8 percent of GDP last quarter, nonfinancial corporate profits are
still quite low relative to output, considerably below their 1997 peak of about 13 percent of GDP.3 The
general weakness in the economy has, of course, played a role in holding down profits, but, ironically,
the stock market's decline itself has also been a factor. By some estimates, because of asset-price
declines, the defined-benefit pension plans of U.S. firms swung from being about $250 billion
overfunded to being $200 billion to $250 billion underfunded between 2000 and 2002, necessitating
large contributions to these plans that must be charged against operating profits.4 As these losses on
pension fund assets are by convention amortized over time, firms' pension contributions will depress
reported profits at least for the next couple of years (and, incidentally, raise reported compensation to
workers). I think one should note, however, that from a purely economic point of view, losses
associated with pension fund commitments should be treated as bygones and thus in principle should
not affect the willingness of firms to undertake new capital investments, except to the extent that they
affect firms' ability to finance those investments.
Besides weak profits and the large decline in stock prices, the other obvious negative for the corporate
sector is the evident deterioration in aggregate credit quality. The average spreads between yields on
risky corporate bonds, such as BBB-rated bonds or high-yield corporate debt, and the yields on safe
debt of comparable maturities are currently at elevated levels, equal to or above those seen in the
1990-91 recession. Many companies have had their debt downgraded by ratings agencies, and
corporate bond defaults during 2002 amounted to 3.2 percent of the value of bonds outstanding, a rate
above the 1991 peak in default rates.
Although these statistics are certainly worrisome, a closer examination reveals several mitigating
factors. First, though average spreads of risky corporate debt remain high on an absolute basis, they
have recently improved substantially. Spreads on BBB-rated corporate debt have come down nearly
one-third since their October 2002 peak, and high-yield spreads are down about one-fifth. Risk as
measured by credit default swaps has also come down substantially over the same period. At least
some of the recent marked improvement in perceived default risk and market liquidity must arise from
increasing confidence among investors that we have seen the last of the major accounting scandals
that rocked the markets during the summer. If more time passes without new revelations of corporate
wrongdoing and if the generally high level of risk aversion in markets continues to moderate (perhaps
with decreasing geopolitical risks), we should see further declines in corporate yield spreads over this
year.
A second mitigating factor is that much of the measured deterioration in aggregate credit quality is
actually concentrated in a few seriously distressed sectors, such as telecommunications, airlines, and
energy trading firms, with a few high-profile cases making significant contributions. In particular, yield
spreads in the telecom, cable, and media industries reached dizzying heights in mid-2002, though
recently these spreads have fallen quite markedly. Remarkably, for the entire year 2002, telecom firms
accounted for 55 percent of corporate bond defaults, by value. A similar story, though not quite so
extreme, applies to energy and utility firms. When these most troubled sectors are excluded, the
recent behavior of financial indicators for the corporate sector looks far less unusual.
Though less evident than the headline statistics about earnings and stock prices, there is also a
positive financial story to tell about corporate America over the past couple of years. Specifically, as in
the case of households, the recent low-interest-rate environment has allowed firm managers to
restructure their balance sheets in ways that have made them financially better prepared to expand
their businesses when they judge that the time is right. First, by borrowing at lower rates and
refinancing old loans, firms have been able to significantly reduce their current interest charges. The
ratio of interest expenses to outstanding debt for nonfinancial firms indicates that the average interest
rate has fallen about 1-1/4 percentage points from its recent high at year-end 2000, to under 6 percent
on average. With lower interest rates and higher profits, the average ratio of firms' interest expense to
cash flow improved considerably in 2002, to about 18 percent (compared with a peak of 27 percent in
1991). Second, firms have also restructured by substituting long-term debt for short-term obligations,
resulting in a sharp decline in the average ratio of current debt to assets. Average liquidity also
improved markedly in 2002, reflecting declines in short-term liabilities, higher cash flows, and reduced
payouts to shareholders. Finally, on net, firms took on little new debt last year. The bottom line from
this restructuring activity is healthier balance sheets for many firms.
So, are firms financially able to fund new investment and new hiring, if and when they decide that
expansion is justified by the fundamentals? I think that, for the most part, the answer is "yes." Most
firms have ample cash and liquid assets to fund investment internally, and they have access to the
capital markets as needed to fund investment externally. Though risk premiums remain elevated and
lenders are selective, both the corporate bond markets and bank lending windows are "open" to
reasonably sound borrowers. Indeed, over the past year gross issuance - even of speculative-grade
bonds - continued at a moderate pace. The possible exceptions to the presumption that funds are
available are the weakest firms in the most troubled sectors. These firms are generally also the ones
with the poorest earnings prospects and the most severe problems of excess capacity, and hence they
are likely the firms with the least promising opportunities for investment.
The financial strength of the banking sector
Finally, a brief word about banks.
The availability of funds to households and firms depends, of course, on the financial stability of
lenders as well as that of borrowers. Historically, there have been numerous occasions in which
financial problems in the banking system have slowed economic growth, such as in the
already-mentioned case of Japan. How has the U.S. commercial banking sector held up in the latest
recession?
Despite some high-profile lawsuits and regulatory settlements arising from the accounting and stock
analyst scandals of last summer, the answer in this case is "quite well." Following the setbacks of the
early 1990s, over the past decade U.S. commercial banks have maintained consistently high profits
and returns on assets through their efforts to contain costs, to increase their sources of non-interest
income (such as fee income), and to maintain high standards of credit quality. Loan-loss performance
has improved steadily, not only because of better credit evaluation techniques but also because banks
have learned how to manage credit risks better, by making much greater use of secondary loan
markets, derivative instruments such as credit default swaps, and other tools. To a remarkable degree,
the profitability and liquidity of the 1990s has been maintained through the past two years of economic
weakness.5 Some of the factors supporting profitability in the banking sector since 2000 include large
inflows of cheap core deposits (as households have retreated from riskier investments), booming
business in mortgage originations and refinancings, strong demand for credit cards, and capital gains
on securities holdings.
Capital adequacy in the banking sector remains good; it has been boosted both by increased retained
earnings and by banks' shifts into assets with relatively low risk weights, such as government
securities and residential mortgages. Loan-loss experience in the past two years has worsened
slightly; credit quality has been a particular concern in the corporate sector, with a number of
high-profile bankruptcies affecting a number of large banks. In contrast, however, delinquency and
charge-off rates on commercial real estate loans declined in 2002 from already low levels, despite
negative trends in market rents and vacancy rates. The solid performance of commercial real estate
loans contrasts sharply with the difficulties experienced in the late 1980s and early 1990s and may
reflect, in part, tighter lending standards by banks, which were reported in the Federal Reserve's
Senior Loan Officer Survey as