The Consumer-Dependent Economy

The dependence of the U.S. economy on consumer spending is nothing new. At nearly 71% of GDP, consumer outlays are not only up significantly from earlier years, but also much higher than in most other major countries. Gary Shilling explores…

The role of American consumers in promoting economic growth in the U.S. and, indeed, in many export-driven foreign countries will be especially significant in coming quarters. The effects of the previous huge federal tax cuts and rebates are over. And the leap in federal spending for homeland security and military action in Afghanistan and Iraq is over, so federal spending’s share of GDP has leveled.

At the same time, the stimulative effects of earlier Fed credit ease have been reversed. Housing remains strong but the bursting of that bubble may be near, I believe.

While the Fed’s rate increases have had little effect on housing or other economic activity, three realities are clear. First, tighter credit is simply not stimulative to the economy and in fact is constrictive, one way or the other, sooner or later. Two, history says that the Fed will tighten until something happens, and that something almost always is a recession. Third, with Treasury bond yields falling, the Fed will probably need to invert the yield curve to get short rates where it wants them. That situation is very rough on banks and other financial institutions that rely on a positive spread between the long rates at which they lend and lower short-term borrowing rates. In the post-World War II era, the Fed has precipitated recessions without inverting the yield curve, but when it does invert, a recession is almost assured.

Consumer Spending Growth: Carrying the Economic Ball

Elsewhere in the economy, capacity utilization here and even more so abroad remains so low and business caution so subdued that a capital spending boom big enough to lead the economy is unlikely. Indeed, the first quarter weakness in nonresidential fixed investment growth may suggest even less stimulus from this sector in future quarters than earlier.

U.S. consumer spending strength has been reflected in rising imports while sluggish exports follow from subdued economic activity in Europe and the zeal in Asia to export, not import. This negative and growing trade gap is, of course, a drag on the U.S. economy.

With consumer spending growth about 1/2% faster than after-tax income on average for over 20 years-and that’s what the decline in the saving rate tells us-American imports grow 2.9% for every 1% rise in GDP. In contrast, this propensity to import is much lower in other major countries.

By process of elimination, then, it looks like the economic ball will need to be carried by consumers in the quarters ahead. Will they have the income to do the job? Personal Income grew 6.7% in the 12 months ending May 2005, or 4.3% after subtracting the 2.4% year-over-year rise in the Personal Consumption Expenditure deflator. That’s a healthy clip, and is much greater than the first or second quarter annual rate rises in GDP. But is it sustainable?

The 7.2% year-over-year growth in total compensation and 7.0% rise in wages and salaries might suggest so, but these numbers hide some important details. The financial services industry did well last year, and bonuses and commissions were robust in the fourth quarter.

But, much of the bonuses and commissions go to high-income people who tend to be big savers. Meanwhile, lower-income people who depend on weekly paychecks have seen their real weekly pay continue to decline. Part of the reason for the weakness in real wages is that U.S. employment is shifting from high-paid areas like manufacturing to low-pay areas such as leisure and hospitality.

Furthermore, much of income growth for Americans comes from working more hours. A recent study found that in the 1970-2002 years, annual hours per capita rose 20%.

The net result has been a recent leap in the share of income going to the top 20% of Americans while the other four quintiles’ shares keep slipping. Indeed, a recent survey found that the number of U.S. households with a net worth of $1 million or more, excluding their residence, jumped 21% last year.

US Consumer Spending: Wage and Competitive Pressures

Pressure on wages will probably continue. The explosion in profits in recent years is unlikely to continue as most of the low-hanging fruit of restructuring has been picked, and the rebound from the corporate trouble of the early 2000s is over for the vast majority of companies. Meanwhile, global competitive pressures remain intense. A move from the second quarter’s 8.2% toward the long run 5% mean for profits’ share of GDP seems likely, especially since in the long run, profits actually grow slower than the overall economy or corporate sales.

In this climate, business is likely to press labor costs harder, much as it did in 2002-2003 when hiring was curtailed and the resulting robust productivity growth flowed to corporate earnings. One reason employers are concerned about wages and employment levels is the rapid rises in medical, pension and other fringe costs.

Dividend income is benefiting from the pressure on companies in the post-Enron/Arthur Andersen world to pay more to shareholders. But big overall dividend jumps will be difficult even though the current dividend yield, 1.7%, is well below the previous 3% floor.

In the post-World War II era, the payout ratio, the percentage of after-tax profits paid as dividends, has only been at 60% or higher in recessions when earnings fall faster than dividends. Yet with the current 19.3 P/E on the S&P 500 index, a 3% dividend yield over time calls for almost a 60% payout ratio as the average.

It appears, then, that personal income growth in the quarters ahead will not be sufficient to provide the money consumers need to sustain rapid economic growth. But that won’t necessarily deter them. They can fuel their spending the old fashioned way-by increasing borrowing and reducing saving. In pursuing these tried and true techniques, however, consumers do face some new challenges.

One is the recent, tighter bankruptcy law, which makes bankruptcy much less desirable. Now, filers with incomes above their state’s median and with the ability to repay some debts must file under the more stringent Chapter 13 and must undergo credit counseling at their expense six months before filing. They also must repay in full auto loans within 30 months of filing and they can’t file for Chapter 13 more than once every two years.

Another challenge for consumers is that not only debts but debt service, the monthly payment of interest and principal, continues to leap and, in relation to DPI (after-tax income), is much above the mid-1980s peak. Interest rates are much lower now, but the principal owed has exploded.

Back in the late 1990s, many argued that the saving rate as structured by the National Income and Product Accounts was irrelevant because it excluded capital gains, which were plentiful at the height of the dot com bubble.

US Consumer Spending: The Real Wealth Effect

Sure, many consumers considered those capital gains as saving. They felt wealthier and spent lavishly even if those gains weren’t cashed in. That spending, of course, fueled the economic boom that accompanied the stock bonanza. Economists call this the “real wealth effect.” But with the collapse in tech stocks, those capital gains disappeared and so did the criticism of the saving rate definition.

But with the recent leap in house prices, the idea that capital gains are savings is back. Some note that even though capital gains are not included in income as defined by the NIPA, the taxes on them are included in the income taxes that are subtracted from income to ultimately arrive at saving. So, they contend, even the NIPA definition understates saving.

This effect is really small, however. Even in 2000, a huge year for capital gains, removing capital gains taxes would have only increased the saving rate by 1.7 percentage points to 3.0%, still well below the 12% level of the early 1980s.

Regardless of how personal saving is defined, unless house prices leap forever, or the stock bubble revives, most Americans’ assets are totally inadequate to support them in retirement. And, the almost nonexistent saving from current income means that those net assets are being augmented year by year at trivial rates. A recent study of Federal Reserve data found that the households headed by baby boomers had median financial assets of $50,700. With a 5% annual withdrawal rate, that would generate only $2,535 annual retirement income.


Gary Shilling
for The Daily Reckoning

August 30, 2005

Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter.

Prescience has empowered Dr. Shilling to beat the stock market by a wide margin over many years while providing consistently accurate forecasts to his subscribers. Twice ranked as Wall Street’s top economist by polls in Institutional Investor, Dr. Shilling was also named the country’s No. 1 commodity trader adviser by Futures Magazine. And last year, MoneySense ranked him as the third best stock market forecaster, right behind Warren Buffett.

A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending? Are You Ready? in 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet.

We began the summer trying to think new thoughts. We end it thinking the same thoughts we had when it began: what a glorious fin de bubble period it is!

Lesser mortals may criticize Alan Greenspan. That he is a scoundrel we have no doubt. He encouraged householders to mortgage their houses at adjustable rates. He assured that public that mortgage debt was no problem. He held rates below consumer inflation levels for two years – which was like offering an obese man a chocolate éclair. And he enabled George W. Bush’s move to federal insolvency – helping him turn a $200+ billion pseudo surplus into a genuine $400+ billion deficit.

But we praise him. We laud the man the way we would a good circus clown; he makes us laugh. Who else would have the greasy gall to lecture the nation about the dangers of debt – when no other human being on the entire planet is more to blame for it than he?

“Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes liquidation of the debt that supported higher prices,” said the Maestro last week.

As the Great Mogambo would say: Hahahahaha.

What a mountebank. What a cad. What a shyster.

We love him.

People have to play the roles that are thrust upon them by history. Alan Greenspan might have remained the sensible incompetent that he used to be when he was giving corporations economic advice. But how could that bring the nation to ruin? How would that help bankrupt the American middle-class? How would that help the American empire in its quest for absurdity?

More important, what would we do for amusement?

The Fed chairman is warning the nation. He is telling us how the fabulous credit expansion that he engineered is likely to end. When people grow fearful they will begin to sell out of the “assets” they once expected to go up. A bird in the hand will seem more fetching than the two that were supposed to be in the bushes.

Greenspan does not mention that many, many people are likely to be disappointed, even upset, when their birds get away from them. He does not worry that they may form into a mob, that they may get themselves a suitable length of rope, and that they may go looking for someone to dangle from it. Or that a certain humbug economist with the initials A.G. would be a reasonable object of their attention. He does not mention it, because it is not likely to happen; the poor rubes will never figure it out.

Just look what they’re doing now; they too are playing their roles. We wondered why increases in the price of oil had not caused consumers to cut back. Everybody knows that there’s little slack in the typical household budget. There are no savings to draw upon, in other words. Most families save only a penny or so for every dollar they make. And yet, as the price of gasoline rose, we saw little let-up in consumer spending. How was it possible?

Cometh the answer in yesterday’s financial press:

From last year to this, says a Reuters article, credit card use at convenience stores, where most people buy gasoline, has risen nearly 50%.

A gallon of gasoline cost, on average, $2.61 last week, according to Triple A. Charged to a credit card, it ends up costing the consumer as much as $3, including interest and penalties. It is certainly unwise to put current expenses on a credit card – unless it is merely a convenience and paid off immediately. But that is what consumers must do – unwise things. They have been put up to it by the Fed chairman…and by history itself.

We quoted another passage from the Maestro yesterday. Periods of low-risk perception lead to periods of high loss, he almost said, failing to mention his own role in lowering risk perceptions. In this, he is certainly correct. But what a dull world it would be if people always perceived risk accurately. What a dull world it would be if Fed chairmen really did look out for the nation’s money and otherwise kept their mouths shut. What a dull and depressing world it would be if people did reasonable things.

In any case, it wouldn’t be our world.

More news, from our team at The Rude Awakening…


Eric Fry, reporting from Manhattan:

“Clearly, in Laguna Beach, money is no object…and neither is fuel efficiency. Elsewhere in the Los Angeles area, appearances have become so important – especially automotive appearances – that many Angelenos are stretching their pocketbooks to the limit, just to ‘make the cut,’ socio-economically speaking.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening:

From Laguna to London


Bill Bonner, with more random thoughts…

*** “Fasten your seatbelt – peak hurricane season isn’t until mid-September through mid-October, and we’ve had two hurricanes hit the Gulf coast already,” said Deborah White, senior energy analyst at SG Commodities in Paris.

While the folks in Louisiana, Mississippi and Alabama assess the damage from Hurricane Katrina – some parts of the French Quarter in New Orleans are under 30 feet of water – crude oil and gasoline prices are taking a beating.

Gasoline has hit a record $2.25 a barrel, and crude oil is over seventy dollars – at $70.90. Energy officials have gone into panic mode, Saudi Arabia moved quickly to pledge an extra 1.5 million barrels of oil per day to the U.S. markets…and Bush is talking about dipping into the Strategic Petroleum Reserve.

The reserves would be used to provide refineries a temporary supply of crude oil to replace interrupted shipments from tankers or offshore oil platforms affected by the storm.

*** Our world is delightfully; agreeably mad (here, we return to our old thoughts and welcome them back like a prodigal son.)

Yesterday’s news also brought an old familiar item: the future cost of U.S. government promises and commitments to creditors, retirees, veterans and poor people (in present value) has risen to $350,000 per full time worker, says U.S.A. Today.

“Our profligate ways at home are mirrored in Washington and in the global marketplace, where as a society America spends $1.9 billion more a day on imported clothes and cars and gadgets than the entire rest of the world spends on its goods and services. “

Does anyone care enough to do anything about it? Are you kidding?

“A new Associated Press/Ipsos poll finds that barely a third of Americans would cut spending to reduce the federal deficit and even fewer would raise taxes.”

Nope. You can’t destroy a great empire by being reasonable. And you can’t ruin a great people by being careful. History requires both things to happen (otherwise, history would have to stop), so it needs acts of recklessness on the part of the people and their government. That is why we have the war in Iraq, a $700 billion trade deficit, and a $400 billion Federal deficit.

Continues USAT:

“A chorus of economists, government officials and elected leaders both conservative and liberal is warning that America’s nonstop borrowing has put the nation on the road to a major fiscal disaster – one that could unleash plummeting home values, rocketing interest rates, lost jobs, stagnating wages and threats to government services ranging from health care to law enforcement.”

David Walker, who audits the federal government’s books as the U.S. comptroller general, put it starkly in an interview with the AP:

“I believe the country faces a critical crossroad and that the decisions that are made – or not made – within the next 10 years or so will have a profound effect on the future of our country, our children and our grandchildren. The problem gets bigger every day, and the tidal wave gets closer every day.”

And here comes the punch line:

“Federal Reserve Chairman Alan Greenspan echoed those worries just last week, warning that the federal budget deficit hampered the nation’s ability to absorb possible shocks from the soaring trade deficit and the housing boom. He criticized the nation’s “hesitancy to face up to the difficult choices that will be required to resolve our looming fiscal problems.”


*** Addison is remaining tight-lipped about his grand announcement coming this Friday. But, dear reader, he assures me it will be the biggest financial event in Daily Reckoning history. We’ll see. But for now all I can tell you is to stay tuned. Look for more tomorrow…

The Daily Reckoning