As you know from my recent posts, I spend a lot more time thinking about balance sheets and a lot less thinking about GDP, than most economists. In this post I want to look at the balance sheet of the household sector. The most recent data from the Fed’s Flow of Funds report show that at the end of Q4/2008 (12/31/08) households (including nonprofit organizations) owned the following mix of assets.

Households hold 62% of their assets ($40.8 trillion) as financial assets like deposits, T-bills, bonds, stocks and mutual funds. They keep 31% ($20.5 trillion) in real estate assets, and they hold 7% ($4.4 trillion) in the form of consumer durable goods like used cars, old washing machines and computers (in all 38%, or $24.9 trillion in tangible assets). As I have written for years, these percentages represent portfolio choice decisions for people based on their perceptions of return and risk for each asset class. These portfolio decisions are exquisitely sensitive to changes in tax rates and monetary policy.

The table above shows the history of household balance sheet composition. The first thing to notice is the household balance sheet numbers are huge when compared with GDP (roughly $14 trillion per year) or its components like consumption, investment, net exports and government spending. At the end of 2008, people owned $65.7 trillion worth of total assets, made up of $24.9 trillion of tangible assets and $40.8 trillion in financial assets.

The tangible assets, in turn, can be divided into $20.5 trillion in real estate assets and $4.4 trillion in consumer durable goods. It makes sense that the assets on our balance sheet are so big. They represent all the economic activity that has ever happened–all the buildings we have built, all the cars and washing machines we have ever made–less the ones that are no longer in service. In the case of autos, for example, there are more than 15 used cars and trucks on the road and in the driveways for every one that will be produced (i.e., that will appear in the GDP accounts) in the U.S. this year.

In spite of what you read in the headlines, total household liabilities, including mortgages, installment credit and credit cards, add up to just $14.2 trillion. Net worth is a whopping $51.5 trillion–more than 3.6 times total debt and almost five times disposable personal income of $10.6 trillion.

So where is the financial crisis we read about? It is in the behavior of asset values over time. Our net worth of $51.5 trillion is $12.9 trillion (20%) lower than it was just 6 quarters earlier in Q2/2007. That puts our net worth roughly where it was at the end of 2004 ($51.9 trillion) but still much higher than it was a decade ago in 1997 when it was $33.3 trillion.

You can also see from the figures when the trouble started. Tangible asset values peaked in Q1/2007 at $28.4 trillion; since then they have declined by $3.5 trillion or 12.3%. Financial assets peaked 2 quarters later in Q3/2007 (when the leveraged loan and asset-backed securities markets froze up) at $50.5 trillion but have declined by $9.7 trillion or 19.2% since then. Essentially all the adjustment in both types of assets was due to price decline; the physical stocks of tangible and financial assets did not materially change during this period.

When asset values change abruptly, as they did over the past two years, it is always a demand story. That’s because over a short period asset supplies can’t change by much because new asset creation and retirement are small compared with the stock of outstanding assets. In this case it was the sudden drop in demand when investors pushed away from the asset-backed securities market a year and a half ago.

JR

California’s budget mess is front page news. Some are trying to figure out whether they can (or will) cut spending enough to live within their means. Others are looking for new revenue enhancers–we don’t call them taxes anymore or people will vote them down in elections. Both are missing the point. It’s not only the budget, but the balance sheet that needs attention.

California does not only have a tax and spend problem; it has a balance sheet problem. There are too many promises of future cash flow to pay for pensions and the like. California needs a balance sheet solution. Not the one that failed in last week’s election—borrowing more money and accounting with mirrors. California needs to sell assets and shrink liabilities in order to regain financial health. When a person or a company declares bankruptcy the judge takes your house, your car, your toys and your other ‘stuff.’ Although state governments cannot, formally, declare bankruptcy, the same medicine will work for them as well. Easier said than done.

Yesterday I wrote about the strange accounting practices for government entities used by the Federal Reserve Board in preparing their quarterly Z1: Flow of Funds of the United States reports. They provide detailed information about cash receipts and cash disbursements for federal, state and local governments, consolidated on p. 110 for all levels of government. They include the information on current receipts (tax collections) and current expenditures as well as information on government purchases and sales of all sorts of assets including spending to buy fixed assets (buildings etc., $513.1 billion annual rate in Q4/08). But in the consolidated balance sheet, which I have reproduced above, they conveniently forget to mention that governments own real assets.

According to the table, All levels of government owned $3280.4 billion in financial assets and had total liabilities of $10,171.3 billion on 12/31/08, which seems to imply that governments had a negative net worth position of nearly 7 trillion dollars (-$6,890.9 billion). But where are the $513.1 billion in fixed assets they reported governments buying in the flow of funds table? Indeed, where are all the other tangible assets–the land, the buildings, the machines, the trucks and buses) the governments purchased in all the previous periods? If they had included government holdings of tangible assets the statements would look much different. Indeed, they would reveal the immense stockpile of real assets on government balance sheets that are available for sale to meet the government obligations everyone is writing about. The federal government, for example, owns more than 700 million acres of land (not reported on their balance sheet either). These assets can be sold outright or they can be sold and leased-back. Either way the cash is available to pay obligations. Either way we would have more honest financial statements.

JR