Debt, Delusion, and Deception
The Fed continues to stand by their claim that the U.S. economy is just experiencing a “soft patch” that will surely be followed by high rates of economic growth. Dr. Richebächer stands firm in his belief, too – that the worst has yet to come…
The skyrocketing wedge between debt growth and GDP growth is definitely the most spectacular and most frightening phenomenon of the economic and financial development in the United States. In relation to lagging income growth, the wedge is considerably bigger. Yet it receives zero attention by the Federal Reserve and the permanently bullish consensus.
Due to higher inflation, higher short-term rates and compound interest, ever-increasing amounts of credit are required to maintain their effects on spending and asset prices. Signs of a slowing global economy are abounding, led everywhere by the manufacturing sector. Downward surprises are chronic. The U.S. economy is no exception.
Our highly critical assessment of the U.S. economy is mainly determined by two extremely negative considerations: First, its chronic structural imbalances between consumption, saving, investment and debt creation have dramatically worsened since 2000; and second, both monetary and fiscal policies have virtually exhausted their stimulatory potential. There is little or nothing left for them to do when the economy slides back into recession.
It is the particular feature of U.S. economic growth since the late 1990s that consumer spending has increasingly outpaced the growth of production. Its counterparts are a collapse of saving out of current income, weak business fixed investment and the soaring trade deficit. Actually, business borrowing goes mostly into mergers, acquisitions and dividend payments.
The most striking hallmark of this escalating divergence between consumption and output in the U.S. economy has been the exploding U.S. current account deficit, presently running at an annual rate of close to $800 billion. This is more than six times its amount of $109.5 billion in 1995.
It seems that U.S. policymakers and economists have yet to realize that this deficit is the economy’s great income and profit killer. To offset the implicit huge drag on U.S. domestic production, employment and incomes, the Federal Reserve has kept its money and credit spigots wide open to create alternative domestic demand.
Structural Imbalances: A Firm Footing?
In his congressional testimony on June 9, 2005, Federal Reserve Chairman Alan Greenspan described the U.S. economic situation to be “on a reasonably firm footing.” Looking at the following monthly figures from the Bureau of Economic Analysis’ (BEA) Personal Income and Outlays report, we note a dramatic deterioration in income growth and spending growth.
This table finds very little attention. In reality, it is of eminent importance because it shows changes in consumer incomes and spending on a monthly basis. Given the high share of consumption in GDP, it is the best proxy for current GDP growth. For the first two months of the second quarter, April – May, consumption is up 1.2% at annual rate.
The published numbers for the gains in real disposable income are actually so disastrous that we hesitate to take them at face value. Real disposable income in May 2005 was $8,211.6 billion, down sharply from $8,473 billion in December 2004.
Assuming a big distortion from December to January, we focus on the four months February – May. Over these four months, the real disposable income of private households edged up a miserable $37.7 billion, equal to an annual growth rate of 1.5%. For comparison, real disposable income grew 3.7% in 2004 and 2.3% in 2003. It seems reasonable to describe this as an income collapse.
Over the same four months, consumer spending in chained dollars surged by $75.7 billion, but with a steep downtrend: February, $32 billion; March $28.6 billion; April, $18.1 billion, May – $3 billion.
There is no secret as to how the American consumer has been pulling this off. It is all about an economy in which demand growth through income creation has been increasingly replaced through inflating asset prices providing the collateral for ever-higher spending on credit. But income creation is not catching up; it is in dramatic decline.
Structural Imbalances: The Reasons for the Spending-Income Gap
We are looking for the deeper macroeconomic causes behind this rapidly widening gap between consumer spending and consumer incomes. These reside in the two major structural imbalances, which policymakers and economists in the United States stubbornly refuse to regard as a problem.
The paramount reason is the soaring deficit in the U.S. economy’s current account, reported at $195 billion for the first quarter of 2005. This sum reflects current spending of many different kinds in the United States. The recipients of this huge amount, however, are foreigners enjoying a corresponding rise in their current incomes.
These big income gains on the part of the surplus countries implicitly have their counterpart in a commensurately big income leakage on the part of the U.S. deficit economy. With its soaring current account deficit now close to $800 billion, or well over 6% of GDP, it would long be in deep recession.
To offset this enormous trade-related income drag cogently requires compensating credit and debt creation to generate alternative demand. That is what the Fed has done with its persistent extreme monetary looseness. Thus the monstrous trade deficit has trapped the U.S. economy in a vicious circle of growing credit excess.
But as the demand for manufactured goods is increasingly met by foreign producers, the alternate domestic credit creation increasingly feeds service jobs, of which a large part is low-paying. Another point to consider is that different types of expenditures have very different aftereffects. Just compare in this respect the difference in income creation between spending for health service and spending for building a new factory. In short, easy money replaces the good jobs that emigrate by bad service jobs.
In our view, gross lack of investment spending with high multiplier effects is America’s second biggest macroeconomic deficiency.
In line with Austrian theory, we regard capital spending as the critical mass in the capitalist process, generating all the things that make for true prosperity. First of all, it creates employment, income and tangible wealth from the demand side while the plant and equipment are produced. Then, upon their installment, all these capital goods create employment, productivity and income from the supply side.
And there is still a third point to be considered. First, capital investment is self-financing; and second , depreciations and their reinvestment create an endless stream of recurrent employment and income without any additions to debt. Investment-driven economic growth, therefore, has a very low debt propensity. In contrast, unproductive government and consumer debt automatically feed on themselves through compound interest.
There was a drastic break in the U.S. economy’s debt propensity from the early 1980s, similar to the late 1920s, but considerably worse. In both cases, it had the same two causes: booming consumption and financial speculation.
Earlier, we emphasized that the U.S. economy’s prospects is presently the all-important question for the global economy. The popular spin, trumpeted by Mr. Greenspan in particular, is that the U.S. economy possesses such extraordinary resilience and flexibility “that its imbalances are likely to be adjusted well before they become potentially destabilizing.”
Structural Imbalances: Imbalances Soar
It is an absurd statement; because flexibility is the last thing the U.S. economy has shown in the past few years. Its one and only flexibility has been in the creation of a housing bubble and the associated credit bubble, while all the structural imbalances – rock-bottom savings, asset inflation and the monstrous trade deficit – have soared to new extremes.
Duly, the U.S. pattern of the economy’s downturn in 2000-01 has diametrically differed from the typical, cyclical kind. All past recessions were triggered by monetary tightening, the Fed’s response to rising inflation rates. Consistent with tight credit, consumers and businesses slashed their credit-financed expenditures. These were the same components in all economic downturns – consumer durables, business investment and residential building.
This downturn has been unlike anything ever experienced in the annals of the business cycle. While the Fed undid its 1998 rate cuts in the first half of 2000 – raising its federal funds rate in three steps by a total of 1%, to 6.5% – credit flows to businesses and consumers escalated as never before. Yet real GDP growth slowed sharply from 3.7% in 2000 to 0.8% in 2001. It was the first recession to happen under conditions of rampant credit expansion.
But what distinguished the 2001 recession most radically from all past experience was its pattern. The downturn had centered on one single demand component – business fixed investment. With a plunge of 13.1% in 2001-02, it experienced its sharpest fall of all postwar business cycles. In an equally unusual fashion, consumer spending simultaneously surged by 5.8%. Clearly, the extraordinary developing consumer borrowing-and-spending binge moderated the economy’s downturn.
The following recovery has been just as diametrically different from past experience. With the lowest interest rates in half a century and the biggest fiscal stimulus in history, the U.S. economy’s recovery from its 2001 low has nevertheless been its weakest by far in the whole postwar period by any measure. The broadest popular measure is real GDP growth. It increased during the three years 2001-04 by 9.6%, as against an average of 14% growth over the same period for previous cyclical recoveries in the postwar period.
But there is a second utterly unusual feature in this U.S. economic recovery. Just as in the case of the prior downturn, its pattern differs diametrically from past experience. The normal V-shaped recovery remains grossly missing.
Three aggregates of crucial importance for sustained strong economic growth show persistent, drastic shortfalls. These are business fixed investment, employment and real wage and salary income.
It should be clear that a recovery’s composition crucially matters for its vigor and sustainability. Typically, past cyclical recoveries got their immediate, strong traction from pent-up demand for business fixed investment, consumer durables and housing generated by the prior tight money. This time, two critical components went badly wrong: Business fixed investment recovered meekly, and foreign trade went into an exploding deficit.
for The Daily Reckoning
July 19 ,2005
P.S. This U.S. economic recovery has been unique in that it rests on one single pillar – the housing bubble, which the Fed systematically engineered to boost consumer spending through easy consumer borrowing against rising house prices. Ominously, this is occurring against the backdrop of unusual weakness in the growth of employment and wage and salary income.
Consumer spending (or rather, consumer borrowing and spending) remains high for one reason only: An irrational confidence in the economy.
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.”
What really counts? What really matters?
We have been thinking about several things at once this summer – some private and personal, others macro-economic. All of which concern values.
Every day, we get new headlines, statistics…new prices…new information. But prices are short-term. They will change tomorrow. Values, on the other hand, change very, very slowly – if at all. Financial theorists say that prices are “perfect” – but they are, in fact, perfectly worthless, for they tell us nothing about what things are really worth. We have to figure that out for ourselves. Besides, prices are subject to change without notice.
And statistics? Almost all the statistics used in economic discussion are misapprehensions, scams or lies. The GDP “growth” numbers tell us how fast the U.S. economy is growing poorer. The inflation numbers tell us only how fast prices are rising for people who don’t exist – those who buy a 1990s computer today! Guess what…it’s cheaper. And the employment numbers are a swindle too, says Paul Krugman in today’s International Herald Tribune. He quotes J. Bradford DeLong of UC Berkeley: “We have four of five indicators telling us that the state of the job market is not that good and only one – the unemployment rate – reading green.” It reads green, rather than black, because it fails to count people who are not “actively” looking for a job. “The addition of these hypothetical participants,” writes Katharine Bradbury, an economist at the Boston Fed, “would raise the unemployment rate by one to three-plus percentage points.”
Why have so many given up looking for a job? We don’t know, but we can guess: because the jobs they had hoped to find no longer exist.
“The United States is being virtually de-industrialized,” writes our favorite economist, Dr. Kurt Richebächer. “The sector has lost 3 million jobs since 2000 and keep losing them month after month.” America used to be a country that made things for export. It employed millions of well-paid people in factories where they made things to be sold overseas. The bars in “industrial” cities, such as Milwaukee and Baltimore, were full of working stiffs with money in their pockets. In the Highlandtown section of Baltimore, for example, near the Bethlehem Steel plant, there was a bar on practically every corner. Now, the old bars in the old working class neighborhoods are closed. The new bars, downtown, have a different clientele – office workers, real estate hustlers, and young professionals. Wine has replace beer at many of these places. Bragging about house price gains has taken over from bar fights. Wage earnings have given way to credit card and mortgage debt.
The good-paying factory jobs are disappearing. A man can still find work – but not necessarily at the same price.
We note in passing that the Dow has gone nowhere for a very long time. From the late ’90s to today, an investor would have made nothing. But in India, stocks have more than doubled in the last three years. These are just prices, of course, not values. But people are beginning to ask questions. Not only are stocks soaring in India, wages throughout most of Asia are rising. How come people are earning more and more in Third World “basketcase” countries…while their hourly wages in America go nowhere?
William Greider takes up the interrogation in today’s IHT. He comes remarkably close to understanding what you, dear reader, realized a long time ag America’s imperial finance business no longer pays.
“Why is the United States one of the few advanced economies that suffers from perennial trade deficits?” he asks. “Why do new trade agreements, despite official promises, always leave the United States with a deeper deficit hole, with another wave of jobs moving overseas? How do the authorities explain the 30-year stagnation of working-class wages that is peculiar to America? Are we supposed to believe that everyone else is simply more competitive or slyly breaking the rules?”
The United States has had a positive trade balance only once in the last three decades, Greider notes, and that thanks to a recession.
And then, Greider comes to a point that makes him a genius and a schmuck at the same time. “The possibility that the United States can no longer afford globalization, at least not as it now functions, is what opinion leaders do not wish to discuss.”
Here at The Daily Reckoning, we are not opinion leaders. Nor opinion followers. So we can discuss what we like. We have made the point many times: globalization no longer favors the global hegemony. That is, it no longer favors the empire that pays for it. The cost of “fighting terror” alone is $150 billion worldwide. America pays $130 billion of it. What does it get for the money? People are beginning to wonder.
More news, from our team at The Rude Awakening:
Chris Mayer, reporting from Gaithersburg, Maryland
“During my two hours with Ralph Wanger, he shared the three key investment tactics that propelled his fund to such dazzling gains…”
Bill Bonner, with more opinions:
*** Greider is a genius because he sees the problem the way we do; he is a schmuck because he is unwilling to look at it square in the face. Instead, he averts his eyes in the usual greasy way…and imagines he sees something shifty. Part of the problem, he says, is that U.S. companies are “generally free – and even encouraged by Washington – to shift production to low-wage locations….The practice works for companies and investors, but not so well for a nation.”
The idea seems to be that the nation would be better off if the people in it were less well off. If a company were forced to make inferior products at home, and sell them at higher prices…somehow the nation would thrive. If anyone understands the logic of it, he’s not working on The Daily Reckoning this morning. But having reduced the problem to a matter of public policy Greider is able to get a grip on it:
“…Governments must together shift the balance of power so labor incomes can rise in step with rising productivity and profits,” he says.
Why not rising stock and house prices too? And longer life spans? And slimmer women…handsomer men…and teenagers without acne or bad manners?
We understand why wages in the Orient go up: because they are making more and better merchandise. But why would wages rise in the Occident, just because governments say so?
*** Your editor’s mother fell over backwards last week and hit her head on a granite step. She is recovering, more or less. But we are all wondering how much longer she will be with us. She says she wants to go back to the U.S. to see her old doctors…and to be close to the rest of the family. “I’ll come back when I feel more sprightly,” she says. We wonder if she ever will.
We can’t help but think these summer days may be the last we spend with her. What are they worth, we wonder?
We have no answer. And so, with moist eyes we turn from the quotidian sorrows of this “deathward going tribe,” as Sophocles put it, to less important matters. That is, we turn from tragedy to comedy…and farce.
Some things are priceless, we recall writing a day or two ago. We have a hunch that price-less things are often under-priced. Since they are priceless, people assume they are worthless. Expensive things, on the other hand, are thought to be worth a lot, even though they may have no value at all.
For easy reference, we have prepared a short list:
Things that are overpriced and overbought:
Stocks – Junk Bonds – U.S. Residential Real Estate – Modern and contemporary art – Terrorism – Republicans & Democrats – Television – Electronic gadgets – Automobiles – Shorts – Casual meals – The Da Vinci Code – Baseball caps – Debt – Newspapers – Suburbs – Employment – Higher education – Shopping – Retirement – Health insurance – Movies
Running shoes – Comfortable clothes
Underpriced or undervalued things include:
Gold – German real estate – Good manners – Privacy – Mothers and Fathers – Crispy duck – Gardens – Wood heat – The Daily Reckoning – Savings – Thrift – Elegance – Walking – Leisure – Europe – Private businesses – Old people – Extended families – Long skirts – Dresses – Hats, especially berets