A Credit Machine Running Amok
The Anglo-Saxon countries have been the high-growth economies among the industrialized economies. By definition, strong economic growth implies that domestic investment exceeds domestic saving. Actually, Mr. Bernanke and others have repeatedly justified the capital inflows with the fact that capital investment exceeds domestic saving.
On the surface, this is true. But this description represents a grotesque distortion of the economic reality. What has truly happened in the United States and the other English-speaking countries is that private households, in response to inflating house prices, have slashed their savings even faster than businesses slashed their capital investments. As a result, minimal investment exceeds nonexistent domestic saving. This explains their stronger economic growth.
To illustrate this with a comparison: In France, the personal saving rate is hovering lately at around 11.4% of disposable income, literally the same level as in 2000. This stability in savings has prevailed despite sharp rises in house prices because everybody in France regards this as inflation, not as saving. Living systematically beyond one’s means is not a way of life in France and many other countries.
In the United States, personal saving over the same period has slumped from 2.3% of disposable income to -1.6%. The key point to see is that the stronger growth of the Anglo-Saxon countries had one single overriding reason, and that was to boost consumption at the expense of savings. If the United States had the savings rate of most European countries, it would be in depression.
Now to the U.S. economy. With zero savings and runaway credit expansion, the United States ought to have sky-high interest rates. Thanks to large bond purchases by the Asian central banks and the virtually limitless availability of carry trade in dollars and yen, implemented by the two central banks, U.S. long-term interest rates have held at absurdly low levels. On the surface, interest rates are determined in the markets. In these two countries, they are heavily manipulated by the central banks.
Strikingly, the Fed’s 16 rate hikes over the last two years have done nothing to curb the recorded domestic credit expansion. Yet dollar carry trade, which also has played an important role in funding highly leveraged asset purchases, is dead in the water, simply because short-term rates have caught up with long-term rates. Astonishingly, the bond market has only minimally reacted.
Barely noticed, the U.S. credit machine ran amok again in the first quarter of 2006, revealing the Fed’s tightening as a farce. Nonfinancial credit expanded $2,914.0 billion, annualized, up from the prior quarter’s $2,434 billion. Together with an increase in financial credit by $1,479.2 billion, the total adds up to $4,392.8 billion.
Compared with an increase by $827 billion in 2000, credit and debt growth has quadrupled. Total outstanding indebtedness rose to $41.8 trillion, equal to 334% of nominal GDP and 376% of real GDP. In the first quarter, $4.30 of additional debt was added for each dollar added to nominal GDP growth and $7.50 additional debt for each dollar added to real GDP growth. Until the late 1970s, this credit-to-GDP ratio had held at a steady rate of 1:1.4 for over 30 years.
In a country without domestic savings, the money for such a runaway credit expansion must implicitly come from credit creation through the domestic financial system and foreign investors and lenders.
Strikingly, in the first quarter, U.S. commercial banks boosted their “net acquisition of financial assets” by a blistering $957 billion, annualized, as against $791.1 billion in 2005 and $472.4 billion in 2000. Net acquisitions of security brokers and dealers surged at an annual rate of 28%, to a record $611 billion. Foreign net acquisitions of financial assets in the United States rocketed to $1.492 billion, against $889 billion in the prior quarter.
Sorry for all the figures, but knowing them is of greatest importance. They contain the solution for the famous “conundrum” of stable U.S. long-term interest rates defying all the rate hikes. There were rate hikes, yes, but measured by the pace of the credit expansion, there has not been the slightest monetary tightening. Instead, the Fed has accommodated runaway and permanently accelerating credit growth.
Nevertheless, as explained, the rate hikes at the short end of the yield curve have cut off the dollar carry trade. But it has been replaced through sharply accelerating U.S. domestic bank credit expansion, and further highly leveraged carry trade in yen, but perhaps also in euro and the Swiss franc and bond purchases by Asian central banks.
Of course, rate hikes are generally applied to put a brake on credit growth and price inflation. The fact that in the United States the credit expansion sharply accelerated exposes the rate hikes as an outright sham. The point is that the Fed kept the banking system liquid enough to continue an aggressive credit expansion.
In the case of private households, the lure of higher house prices has plainly more than offset any restraint from higher interest rates, what a central bank ought to take into account. We doubt that they ever wanted true significant restraint in borrowing and spending, because they are afraid of it happening. They want lower inflation, but not lower spending.
Household debt expanded in the first quarter of 2006 to $1,333.9 billion, annualized, a new record. Business debt soared by $864.3 billion, up from $611 billion in 2005. Financial credit jumped by $1,479.2 billion, against $1,036.7 billion in 2005. Any talk of credit restraint is absurd.
Yet the most important credit source for economic activity during the past few years is running out of steam, not because monetary conditions have become tight, but because the delivery of collateral for higher borrowing against rising house prices has slowed sharply in line with their sharp slowing. Popular year-over-year comparisons, by the way, are deceptive. What matters are the recent changes.
Purchasing power currently spent comes from income or credit. In times of yore until 2000, U.S. private households got their purchasing power, like everywhere else in the world, overwhelmingly from current income, provided by increases in employment and real wages. During 1995 to 2000, overall real disposable incomes rose over 4% per year on average.
Yet since the early 1980s, there has been a steadily growing resort by households to borrowing, as reflected in a steadily falling savings rate. After 10% of disposable income at that time, it was down to only 2.3% in 2000.
From then on, the relationship between income growth and debt growth has radically reversed. Debt growth has escalated ever faster in comparison to income growth. Real disposable income growth, even though heavily bolstered through tax cuts, averaged only 2.7% until 2004. In 2005, absent new tax cuts, it grew a mere 1.3%. Over the first four months of 2006, it has been zero.
This recovery of the U.S. economy since November 2001 has been dominated by an unprecedented consumer borrowing-and-spending binge. In the first quarter of 2006, consumer debts had risen 70% from 2000, against an increase of real disposable incomes by 12%.
American policymakers and economists find it convenient to speak of “asset-driven” economic growth, in contrast to the “income-driven” growth pattern of the past. First of all, we object to this juxtaposition. “Asset-driven” is a euphemism for “bubble-driven,” because what matters is not the existence or creation of assets, but their soaring prices celebrated as “wealth creation.” The second utterly negative point to see is that this asset price inflation has been manifestly driven by ultra-cheap and loose money and credit, and not by saving and investment.
Since 2001, surging house prices providing ballooning collateral for consumer borrowing plus massive fiscal stimulus have been instrumental in offsetting the contractive effects of the bursting equity bubble and in generating the following recovery, but a recovery of gross failings.
With short-term rates now up to 5% and the housing bubble slowing down, the possibilities of borrowing are bound to shrink. To nevertheless maintain further increases in consumer spending, much stronger income growth will be needed either through higher real wage rates or higher employment.
What are the chances? In brief, employment and income growth are worsening. First of all, wage growth is barely matching the rise of the inflation rate. So everything depends on stronger employment growth.
This, however, dramatically deteriorated in April and May. Instead of an expected 400,000 new jobs over the two months, the reported gain was a miserable 208,000, even though the Bureau of Labor Statistics (BLS) fabricated record phantom job growth through its dubious “net birth/death” model – 271,000 for April and 211,000 for May. Yet even including these 482,000 phantom jobs, the reported figures are flatly awful, implying further income stagnation, if not worse.
With these numbers, the BLS is apparently making the ridiculous assumption that employment growth among new small firms outside its survey must be booming, while sharply falling in the economy as a whole, captured by its survey. It is always amazing how readily the consensus accepts such manifest nonsense. Wishful thinking prevails over serious analysis.
Looking at the monetary aggregates, something else strikes us as most ominous, and that is the difference between record-strong double-digit credit and debt growth and record-low growth of the money supply. M1 and M2 gained 3.2% and 4.9% over the last quarters. Adjusted for CPI inflation, this was close to zero for M1 and up just 1.3% for M2. We regard this as ominous because credit stands for debt, while money supply stands for liquidity.
Recently, we made an inquiry among American friends, posing to them the question whether there is any thought or talk in public of a possible recession in the United States. It occasionally pops up in the press, we learned. But the consensus opinion, in particular on Wall Street, flatly discards it as a possibility. It was precisely the answer we had expected.
It is a historical fact that American policymakers and conventional economists have never foreseen a recession. In 2000, the Fed hiked its rate twice during the first half, just before the economy began its slump. Equities already had started to crash in March. Reading several reports with forecasts published in late 2000, among them the OECD Economic Outlook, we found nowhere the slightest hint of a coming recession.
There seems to be a general conviction, cultivated not just by Mr. Greenspan, that the U.S. economy has become virtually immune to recession. It is widely seen as just a bursting of strength due to ingrained “flexibility” and “dynamism.” In addition, there is, of course, unbounded faith in the virtuosity of the Fed to avoid a serious recession with swift action.
Dr. Kurt Richebächer
for The Daily Reckoning