By Far the Weakest Recovery

The Daily Reckoning PRESENTS: For the good doctor, the only question is the severity of the impending U.S. recession. In this respect, he is a great believer in the axiom of Austrian theory that every crisis is broadly proportionate to the size of the excesses and imbalances that have accumulated during the prior boom. Learn how bad the coming months might be…


Trying to assess the situation and further growth prospects of the U.S. economy, the first important fact to see is that the U.S. economic recovery since November 2001 has been by far the weakest in the whole postwar period. Just a few tidings composed by the Economic Policy Institute in Washington:

First, inflation-adjusted hourly and weekly wages today are below where they were at the start of the recovery in November 2001; second, median household income (inflation adjusted) has fallen five years in a row and was 4% lower in 2004 than in 1999; third, total jobs since March 2001 (the start of the recession) are up 1.9% and private jobs 1.5% (at this stage of previous business cycles, jobs had grown 8.8%); fourth, the unemployment rate is low only because several million people have given up to look for a job.

And here are some cursory remarks on our part: First, job growth has steeply fallen during the last three months, from 200,000 in February to 75,000 in May; second, all the job growth has come from the artificial net birth/death model, implying that it is booming among small new firms not captured by the payroll survey, while slumping in existing firms; third, private household indebtedness since 2000 has soared by 70%. This compares with an overall increase in real disposable personal income by 12%.

According to the popular GDP accounts, consumer spending in the first quarter has burst by a record rate of 5.2%. That is the fact on which everybody happily focuses. Few people realize, first of all, that this is an annualized figure. The true increase against the prior quarter was 1.3%.

In any case, though, it is a grossly distorted figure. The ugly reality of the first five months of 2006 is that the consumer-spending boom of the past few years has effectively broken down. But to realize this, it is necessary to look at the sequence of monthly data. Here they are, from the same source as the GDP numbers, the Bureau of Economic Analysis (BEA):

By these figures, measuring spending and income growth from month to month, consumer spending in the first quarter has increased 0.6%, or 2.4% annualized, less than half the 5.2% as reported in the GDP accounts. As we have stressed several times before, the big difference between the figures arises from the fact that the GDP measures changes in averages. The big increase in consumer spending happened in reality in November/December 2005, resulting in a large “overhang” for the following quarter.

To detect a recent change in trend, it is necessary to focus on the changes from month to month, as above. For May, reported retail figures showed an increase by 0.1% before inflation. With a monthly inflation rate of 0.3%, total real spending should be at a minus.

This sudden weakness in consumer spending has an obvious reason. The spending bubble on consumer durables – that is, on autos and housing durables – is going bust. It was largely spending borrowed from the future to be implicitly followed by payback time.

For us, this rapid, steep decline in the growth of consumer spending is the first decisive consideration to expect in the United States’ impending serious recession; and remarkably, this is happening with record credit growth and even before the housing bubble is truly bursting.

That this most important fact goes completely unnoticed says something about the depth of research. Moreover, this sharp slowdown in consumer spending strikingly conforms to the downward shift in the growth of real disposable personal incomes. In 2005, it was already down to 1.3%. So far in 2006, it is zero.

Under these miserable income conditions, the strength of future consumer spending manifestly depends on the possibilities of ever-higher cash-out mortgage refinancing against rising house prices. It hardly requires any intelligence to have realized by now that this is flatly impossible.

Looking at the accelerating credit expansion, we are, as a matter of fact, more than doubtful that the slowdown in the economy and the housing bubble has anything to do with the Fed’s rate hikes. What crucially matters for both is the current credit expansion, and that keeps accelerating. But the problem is that more and more credit creates less and less economic activity, as measured by GDP.

The unrecognized problem in the United States is that economic growth driven by a housing bubble is extremely credit and debt intensive. It needs, firstly, heavy borrowing to drive up the house prices and, secondly, further heavy borrowing to turn the resulting capital gains into cash. Put this together with minimal or now zero real disposable income growth and you have something like a credit Moloch devouring credit and leaving less and less for economic growth.

Yet we are sure that the U.S. economy’s extraordinary debt addiction has other reasons unrelated to the housing bubble. One is the huge trade deficit, and the other is extensive and rapidly increasing Ponzi finance.

The American consensus view holds that the trade deficit, however large, does not matter because foreigners easily finance it. This view reveals the total absence of any serious analysis of related domestic income and debt effects. The obvious first major harmful economic effect is that domestic producers lose an equal amount of domestic spending and income creation to foreign producers, and that today in a staggering annual amount of more than $800 billion, equal to about 7% of nominal GDP.

Such persistently large and growing income losses from the trade deficit would have pulled the U.S. economy into recession long ago. It has not happened because the Greenspan Fed, by way of loose and cheap money, provided for a compensating increase in domestic demand through additional credit creation. It succeeded, true, but the thing to see is the additional credit and debt creation. This was justified with low inflation rates. Ironically, the import boom in the trade deficit has been very helpful in suppressing U.S. inflation.

Yet there is still a second major harmful effect to the trade deficit that American economists completely ignore. Implicitly, the alternative demand created by the looser U.S. monetary policy is different from the demand that emigrates to foreign producers. The big loser is the export industries in manufacturing. The gains, via the surrogate demand, have been in consumer services and goods.

In essence, the trade deficit alters the economy’s structure in a negative way. The losing manufacturing area is the sector with the highest rate of capital formation, and therefore also the highest rate of productivity growth. For good reasons, it also pays the highest wages. Consider that U.S. manufacturing lost 3 million jobs in the past few years. To be sure, the trade deficit is not its only reason, but unquestionably a major one.

Pondering the U.S. economy’s unusually high addiction to credit and debt growth in relation to GDP growth, we are sure of another evil factor – Ponzi finance. Principally, every increase in spending brings about an equivalent increase in incomes. But this is not true in three cases of spending: first, spending on existing assets; second, spending on imports; and third, Ponzi finance.

Ponzi finance means that lenders simply capitalize unpaid interest rates. Ponzi finance creates credit, but it is bare of any demand and spending effects in the economy. In the conventional American view, balance sheets of private households are in their very best shape because increases in asset values have vastly outpaced the sharp increases in debts. So Americans see no problem.

With such great optimism about the U.S. economy still prevailing, it is a safe assumption that lenders have been more than happy to capitalize unpaid interest rates as new loans, at least until recently. As widely reported, lending standards have been extremely lax for years. Nevertheless, there is bound to come a point where Ponzi lending stops.

The crucial difference is in the ghastly difference between runaway debt growth and nonexistant real disposable income growth as the income component from which debt service has to be paid. In 2000, consumer debt growth of 8.6% compared with real disposable income growth of 4.8%. During the first quarter of 2006, private household debt growth of 11.6%, annualized, compared with zero real disposable income growth.

These numbers suggest that, in the aggregate, all debt service occurs through Ponzi finance. Essentially, borrowing against existing assets is required to service debt. Another striking evidence of extensive Ponzi finance is the unusually large difference between rampant credit growth and much slower money growth. Capitalizing unpaid interest rates adds to outstanding credit and debt while adding nothing to bank deposits (money supply).

To get an idea of the actual extent of Ponzi finance, we make a simple calculation. Total outstanding debts in the United States amount to $41.8 trillion. Assuming an average interest rate of 5%, this implies an annual debt service of about $2 trillion. This compares with an increase in national income before taxes of $616 billion in 2005. Consumer incomes are even stagnant.

Under these conditions, the only question is the severity of the impending U.S. recession. In this respect, we are a great believer in the axiom of Austrian theory that every crisis is broadly proportionate to the size of the excesses and imbalances that have accumulated during the prior boom. Our basic assumption is that the American consumer is bankrupt when house prices fall 20 – 30%.

The most important thing to realize is that the spending and debt excesses that have accumulated in the U.S. economy and its financial system on the part of the consumer during the past 10 years are altogether of a size that vastly exceeds the potential for debt service from current income.

With stagnant real disposable income and double-digit debt growth, the American consumer is caught in a vicious debt trap. What, then, makes most people so optimistic of further economic growth? Apparently, there is a widespread view that households have sufficient equity cushions in their balance sheets to not only weather any storm ahead, but also to continue higher spending.

In our view, the most important thing to see is the fact that the consumer has accumulated debts at a level vastly exceeding his abilities of debt service from current income. Probably many never had any intention of such kind of debt service. The general idea, certainly, has been to settle debt and debt service problems simply by selling later to the highly appreciated greater fool. That is what most economists take for granted.

What all these people overlook is, first of all, the vicious dynamics of Ponzi finance through compound interest on unproductive indebtedness. During 2000, total financial and nonfinancial credit and debt growth amounted to $1,605.6 billion. In 2005, it had accelerated to $3,335.9 billion; and in the first quarter of 2006, it has run at an annual rate of $4,392.8 billion, and this now with zero income growth. Note that this debt explosion has happened with little change in GDP growth.

Given this precarious income situation on the one hand and the debt explosion on the other, it should be clear that at some point in the foreseeable future, there will be heavy selling of houses, with prices crashing for lack of buyers.

As to the level of asset prices in the United States, an additional comment is probably needed. Normally, the money for asset purchases comes from the savings out of current income. In the U.S. economy, with savings in negative territory, all asset purchases essentially depend on available domestic credit and capital inflows. Buying assets on credit used to be the exception. In America today, it is the rule. For good reasons, the Fed is fearful to make money truly tight; it would crush the markets.

A study by the International Monetary Fund published in 2003 under the title “When Bubbles Burst” examined the differences in economic effects between bursting equity bubbles and bursting housing bubbles. It left no doubt that the latter are the far more dangerous specimen:

Housing price crashes differ from equity price busts also in three other important dimensions. First, the price corrections during house price busts averaged 30%, reflecting the lower volatility of housing prices and the lower liquidity in housing markets. Second, housing price crashes lasted about four years, about 1 1/2 years longer than equity price busts. Third, the association between booms and busts was stronger for housing than for equity prices.

The situation today in the United States reminds us strongly of late December 2000. At its previous meeting in November, the Federal Open Market Committee directive had called future inflation the economy’s greatest risk. But then, all of a sudden, the bottom fell out of the economy. At its next meeting, on December 19, the FOMC changed the bias, declaring that the risk of economic weakness was outweighing the risk of inflation.

Two weeks later, Jan. 3, 2001, shocked by worsening economic news, the Fed dropped its funds rate, through a conference call, by 0.5% – twice the usual rate.

As we have stressed many times, the U.S. economy today is incomparably more vulnerable than in 2000. All the growth-impairing imbalances in the economy – the trade deficit, the savings and incomes shortage and the debt levels – have dramatically worsened.

Very rapid interest rate cuts and prompt massive government deficit spending succeeded in containing the recession. The phony “wealth effects” derived from the escalating housing bubble became the key source of demand creation in the United States. But the unpleasant longer-term result of the new policies was an unusually weak and lopsided economic recovery, particularly seeing drastic shortfalls in employment and income growth.


Dr. Kurt Richebächer
for The Daily Reckoning

Editor’s Note: The Good Doctor has found the only five investments you’ll need in 2006 – and one of them is a mighty hedge against the forces of dollar weakness and inevitable inflation. At the very least, it will help protect your money from the boneheaded inflationary policies and programs of the Federal Reserve – especially under new Fed Chief Ben “Printing Press” Bernanke.

Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as “the man who predicted the Asian crisis.”

“Fed’s Rate Ruling May Fail to Lift U.S. Stocks as Economy Slows” is the information-packed headline from Bloomberg yesterday.

The financial media thinks it has it all figured out. The Fed will not raise rates today.  And investors, who have already discounted the end of rate increases, will sell shares on the news.

Each era produces its own inimitable theatre – complete with its own heroes, stars and villains. As recently as the 1980s, the world of finance looked to the money supply figures for entertainment. When the new numbers came upon the stage, the audience hissed and booed if they were high, and applauded if they were low. Everyone knew that the money supply was the key to inflation. And everyone knew that controlling inflation was the key to the stock market and the economy.

Now, it is a new era, and the old M3 is so much yesterday’s idol that it has disappeared from the financial news. The feds no longer even announce the numbers…who claps or boos?

Thus has Mister Alan Greenspan transformed the role of the U.S. central banker – previously a bit player on the international financial scene – into a stellar combination…something of the order of Britney Spears’ acting talent crossed with Brad Pitt’s skill as a heart-surgeon. The amalgamation, of course, is likely to prove fatal to the economy.

Thus has Ben Bernanke, former chieftain of the Princeton economics department, sprung into the saddle. The world turns its eyes to him – as if he were Geronimo and Agent 007 combined…a man on whom its fate depends.

His immediate challenge is the one we have described often enough in these daily reckonings. The consumer finally appears to be exhausted. As Ms. Clinton tells us, he cannot work harder or borrow more; he surely cannot save less. His spending power is being undermined – in the lingo of economics – both structurally and cyclically.

Structurally, he faces two billion Asians who have jumped into the global labor pool and would be only too delighted to earn, say, one-tenth as much as the average American.  Cyclically, he stares at his own balance sheet, dripping in red. Egged on for years by Alan “Bubbles” Greenspan, hordes of consumers have been hooked into the bad habit of pressing down on the debit side of the ledger for ready cash. Now, the hapless lumps owe more money to more people than any society ever did. With fuel, housing, education and health bills soaring, they rummage through their pockets only to find they have nothing more to spend.

Even an economist of Mr. Bernanke’s rank can put two and two together. The U.S. economy is nearly 70% consumer spending. When consumers can no longer spend in the style to which they’ve become accustomed, you get a slowdown…a slump…even a genuine recession. It is that simple.

And, the very same price increases that cut into Mr. Average American’s spending money, have also cut into the options Mr. Bernanke, as chief banker, now has.

A central banker, after all, is a magician more than a juggler or sword-swallower. His trade is just as gaudy as theirs, but it uses more legerdemain. Shaking easy money into the economy like confetti, he tricks it into thinking it is richer than it really is. Sales go up; investment increases; the economy booms. But, as Milton Friedman predicted, eventually the additional money drives up prices and people come to realize that they’ve been had. Adjusted for inflation, they’re no better off than they were before. Then, they stop investing, cut back on spending, and the economy stagnates – even as prices rise. The banker thrusts his arm into the credit hat for one last rabbit and comes up empty-handed.

A slowing economy with prices on the rise, better known as “stagflation,” is what you get after easy credit loses its magic.

What can a poor central banker do? What he needs is another hand, but a three-handed banker has yet to appear. Meanwhile, Bernanke can use his one hand to raise rates and fight inflation, or to lower them and fight stagnation.

But not both.

This week, the Fed’s price-fixing committee is scheduled to meet again, and the financial press is abuzz with speculation. What will the Fed do? Raise rates or lower them? The smart money is betting that it will do neither. Instead, the worthy professor is likely to sit on both hands and hope, by some miracle, that he has just the perfect fed funds rate already.

Two bits of news seal the Fed’s course, say the papers: The latest employment report came up 25,000 jobs short. And, British Petroleum closed the pipeline bringing oil from Alaska because it was rusty.

What these two tidbits tell us is something we already knew: the U.S. economy is soft and getting softer. What these two morsels tell the Fed, on the other hand, is that it better not try to raise rates any higher, for, in all probability, it has already piled on that back-breaking 25-basis-point straw.

The show goes on…

More news from the experts at EverBank…


Chris Gaffney, reporting from St. Louis:

“Since a pause has already been priced into these markets, a pause followed by a very hawkish statement or an increase by 0.25%, could give the U.S. dollar support.”

Be sure to read the full issue of today’s Daily Pfennig.


And more random summertime thoughts…

*** Oil trades at nearly $77, and gold is up to around $646.

Are investors rediscovering safety in things that come out of holes in the ground, rather than things that come out of printing presses? Maybe, dear reader, maybe.

*** Property in Britain, as in the United States, seems ready to go down. Still, it has not.  According to the Land Registry, prices are 7.7% higher this year than last, led by our old neighborhoods in London, Kensington and Chelsea, with an 8.6% gain and an average selling price of 808,585 pounds (about $1.5 million).

*** Michael Milken says China’s economy will overtake the United States in this century. Maybe. Even so, the United States will have enjoyed a good run. It took the number-one place in about 1900, shouldering Great Britain out of the way. Since then, it has been the world’s leading economy…and now, its reigning empire.

*** “It’s time,” Addison reports from on the scene in Cannes, France. “The good doctor poked me in the shoulder last night at dinner. ‘It’s time for the United States to collapse,’ he said, with a satisfied smile on his face. ‘The world needs to heal.'”

In a normal economic expansion, Dr. Richebächer contends, credit expansion is roughly equal to the nation’s savings. As 2005 was the first full year in which the U.S. consumer saw a negative savings rate since 1933, the rate of credit expansion should have also been negative.

Au contraire, Dr. Richebächer estimates that for every dollar of GDP produced in the United States last year, over four dollars of credit was created. “We haven’t seen such a bubble as this one since the 1920s. The only difference is…this time it’s much worse,” says the good doctor.

[Ed. Note: We have more on the lopsided “recovery” in today’s guest essay…below. And, we’ll have more from Addison tomorrow. He’s in Cannes helping Dr. Richebächer pull together his magnum opus for publication with the Agora imprint at John Wiley & Sons. It is scheduled for release early next year.]

*** China is a good bet to replace the United States; it is growing very quickly, with wages rising 15% – 20% in a single year. But India is a good bet, too. Colleague Lila Rajiva updates us:

“The India investment story is still hot, but to avoid pitfalls, investors should stay tuned to the nuances. In a recent Forbes piece, for instance, Carl Delfeld, head of the global advisory firm Chartwell Partners, had an explanation of why the Indian tiger might soon be mauling the Chinese dragon. Delfield gives the usual reasons – the Indian tradition of property rights and legal protections, widespread familiarity with English among educated people, a stock market that goes back to 1870, a young population (50% under the age of 25), and growth that is more balanced and less dependent on foreign investment.

“Delfield is right on all counts, but there’s one crucial thing he doesn’t mention. And that is that the Indian population has a high level of technical skill in a number of fields. Computer technology has got the most press so far, but investors should know that India also has an enormous pool of well-trained finance professionals, lawyers, and doctors that it hasn’t yet fully tapped. In contrast, low-wage labor, which is more important to manufacturing, seems to do better in China. That could be partly because India’s low-wage workers have to contend with rigid local labor laws. Or, it could be because of weak primary education and facilities.

“But whatever the cause, the divergence between high-wage professionals and low-wage workers is something to mull over when picking Indian investments. Industries and sectors that depend on skilled professionals are simply a better bet. This means computers and information technology, of course, but it also means financial services, pharmaceuticals, and consulting.

“This angle of the Indian-growth story leaps out at you when you look at something like the Forbes list of the 40 richest Indians. It included 27 billionaires this year, more than double last year’s number. The “fat 40” had a total net worth of $106 billion. That’s up from $61 billion last year, and more than two and a half times what China’s fattest cats are worth ($26 billion).

“Now, check this out. Of the Indian 40, an astonishing one-third makes his money, all or mostly, from information technology, telecommunications, and the media. Their companies include such familiar names as software exporter Wipro, and media giant Zee TV, of course. But, you also see less well-known players, like the Internet casino company, PartyGaming. And, notice that almost one-quarter of these richest 40 Indians are involved in medicine in some way – from Ranbaxy, the pharmaceutical giant, to hospital chain, Fortis.

“That’s the big clue for investors looking for sectors and stocks likely to outperform. Stick with India’s professional knowledge base. Delfeld, for instance, recommends Dr Reddy’s Laboratories (NYSE: RDY) and HDFC Bank (NYSE: HDB). But there are also lesser-known IT stocks, like Satyam Computer Services (NYSE: SAY). And, in medicine, you could look at a generics producer, such as Cipla – or Dabur, which makes herbal products.

“In India, pick the professionals…”

*** A reader writes with a complaint:

“Your remarks re: Mel Gibson are offensive to Jewish readers. Yes, it is a free country and Mel Gibson can say whatever he wants to say, but when a celebrity makes racist remarks, he should be held accountable. Your editor should rethink his statement on this issue.”

We’re so happy we were able to offend someone. We were worried that we were losing our touch.

The Daily Reckoning