Everyone is a genius in a bull market
—old financial saying
Disbelief in magic can force a poor soul into believing in government and business
I would argue that the most serious threat to the United States is not someone hiding in a cave in Afghanistan or Pakistan, but our own fiscal irresponsibility
—David Walker, former comptroller of the United States
Last week I described friedmanism, defined as the dissemination of dangerous positive illusions, in the context of the ongoing sixth mass extinction of life on Earth in the 21st century. I come down to Earth in a different sense today, discussing the dangerous positive illusions that have been evident in the equities and commodities markets lately. I argue that the American economy is likely to be sluggish for many years to come. It's not a hard argument to make.
I am also (not so) amazed to report that the oil price, which now follows the S&P 500see note 1, is over $71/barrel today despite the fact that the weak global demand situation has not changed at all.
Be that as it may, the Bureau of Economic Analysis (BEA) has determined preliminarily that Gross Domestic Product (GDP, or output) in the United States declined at only a 1% annual rate in the 2nd quarter of this year. This news cheered the financial markets, where it is assumed that GDP is now positive in 3rd quarter. Thus traders have convinced themselves that a robust recovery is just around the corner. Newsweek announced the good news with an asterisk (Figure 1).
Figure 1 — The infamous magazine cover indicator. The graph on the right shows Time Magazine's Home Sweet Home cover from June 13, 2005 in the context of the S&P/Case-Shiller home price index. The cover story was America's House Party, from which I quote: "The house has always reflected its occupants' place in society. But now it also determines their place in society. The boom has divided haves from have-nots—owners from renters, hot markets from cold. The median U.S. home price jumped in April to $206,000, up a stunning 15% over the past year and 55% over the past five years, according to the National Association of Realtors. The fact that houses are bought for pennies on the dollar magnifies the windfall." Barry Ritzholtz supplied the graph. You can find Daniel Gross' Newsweek story here.
My story last week did not talk about the truly positive part of positive illusions: if you know how to spot them, they can be very entertaining! Black humor, along with a lively sense of your insignificance in the cosmos, is going to be essential if you want to get through the next decade with all your mental faculties—if not your household balance sheet—intact.
You, me, all of us, are about to experience a propaganda blitz about a recovering economy the likes of which we have probably never seen before. The spinmeisters are going to be out in force because GDP is very likely to turn positive in the 3rd or 4th quarters. Over-exposure to bullish financial media, which is never good for you, will pose an extreme danger to your mental health (Figure 2).
Figure 2 — Successful cheerleaders want to invade your brain. Prepare for a shock & awe psychological assault when GDP edges into positive territory. From Eric Janszen's Explosion Fallout — Part I: Recession Ends, depression begins (iTulip, July 27, 2009).
You have been warned. Today I go back to basics to explain why the United States will remain mired in a deep hole for a long time to come. I need to briefly explain how Gross Domestic Product is calculated and what that really means, but it's not so hard to understand.
Back To Basics
Let's return to the clarity of February, 2009, when the stock market was pricing in a Great Depression, now said to have been averted. The Financial Times' Martin Wolf talked about Japan's lessons for a world of balance sheet deflation.
What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.
As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute.* His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the over-borrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.
[My note: I will not get into the intricacies of the "inflation versus debt deflation" discussion today. I am trying to keep things simple. You can think of the Great Recession as a "balance-sheet recession."]
The United States is in the midst of a balance-sheet recession as households and firms (financial or otherwise) attempt to pay down their enormous debt. Before we look at the debt, let's look at how GDP is calculated.
(1) Gross Domestic Product = PCE + I + G + (Ex - Im)
PCE is classified as private consumption, or in BEA-speak, personal consumption expenditures. It is the spending done by consumers on final goods and services. Virtually all consumer spending is counted excluding home purchases. However this component does include rents paid.
I is the investment portion of GDP. However, as one would typically assume, it does not include purchases of stock and/or bonds since such transactions are essentially just changes of title and do not involve capital goods and/or services. Components of I are business investment in capital goods, and purchases of new housing units by consumers.
G represents the government spending portion of GDP. It represents the government’s purchases of final goods, payment of government employees, and investment in capital goods. Transfer payments such as Social Security and Medicare are not included in the GDP calculation.
(Ex - Im) is essentially our trade balance, with Ex = exports and Im = imports. If we run a trade surplus, then this component contributes to GDP. If we run a deficit, then it subtracts from GDP. Imported goods are subtracted here because they have already been counted once in PCE, I, or G since the goods/services came into the country and were purchased in some manner be it as final goods or capital goods.
[My note: I have slightly edited the original text for clarity.]
GDP is the principal measurement of growth in the economy. If GDP is negative, the economy is said to be shrinking. If it is positive, the economy is said to be growing. Depending on the quarter measured, private consumption PCE makes up 66 to 71% of GDP in the United States. The balance of trade term, (Ex - Im), has been negative for many years because we import more than we export.
The San Francisco Fed published a very important paper in May called U.S. Household Deleveraging and Future Consumption Growth. Figure 3 is going to look very complicated at first glance. I have marked up the Fed's original graph (their Figure 1). This is the one graph you need to understand to get a feel for where the U.S. economy is headed over the next decade, so please take the time to absorb its many lessons.
Figure 3 — The Fed's data key is shown in the upper left. Note that all the lines start out together. Now, look at real household debt (thick black line) versus real household disposable income (thin black line). You can immediately see that the two lines diverge (decouple) in the early 1980s. This is Event I. Now look at housing wealth (dashed black line) versus disposable income. The two trends diverge around 1997. This is Event II. Let's turn to the bubbles. Look at stock wealth (dotted black line). Stock prices lagged real income until the late 1990s, but were rising in support of greater debt. Stock prices then got very bubbly—this was the web/tech (dogfood.com) equities bubble. Bubble tops are marked by light gray arrows & text. The Tech bubble tops out in 2000 and the housing bubble (Event II) tops out in 2006. The entire debt bubble tops out 2007-2008. The vertical gray lines (key lower right) mark the Event I period of debt-based consumption growth, i.e. PCE. Finally, the real income trend line is extended to 2020. Housing wealth versus income reverts to the pre-Event II trend (dashed red line) and most importantly, debt versus income (thick red line) reverts to the pre-Event I trend.
Figure 3 teaches us that what goes up must come down. PCE fell 1.2% in 2009:Q2, but this is just part of a longer future decline. Condensing all the information, we get—
- Phenomenal GDP growth, especially from 1992-2007, depended on ever-greater debt-fueled personal consumption PCE.
- Ever greater household debt depended first on rising stock market wealth, which ended with the tech bubble & crash. However, even as stock wealth declined sharply for a while thereafter, steeply rising house prices stepped in to fill the "wealth gap." This trend ended with the collapse of the housing bubble in 2006.
- The U.S. economy, which was driven by greater debt after the early 1980s and two massive bubbles starting in the late 1990s, must (or should) now revert to the long-term trend which ties debt & consumption to real disposable income & wealth. This will be done by paying down debt over the next decade as shown by the thick red line in Figure 3.
Does it seem complicated? It is not. The simple message of Figure 3 and our conclusions is summarized in Figure 4.
Figure 4 — Saturday Night Live summarizes our economic situation. Watch the video. We can not or should not buy stuff we can not afford for the next 10 years. This could be amended to read "Don't buy stuff you can not afford and do not need."
Now you can understand what Martin Wolf meant when he talked about "balance-sheet deflation." Households and businesses have to pay down their debts for a long time to come. Assets are sold off to pay off debt. If many people are selling and few are buying, asset prices fall, which makes it harder to get out of debt.
The Great Recession is nothing like previous recessions. There can be no "V-shaped" recovery despite CNBC propaganda, which is based on the recent bear market rally—a new bubble struggling to be born—in the S&P 500 and commodities. From Martin Wolf—
First, comparisons between today and the deep recessions of the early 1980s are utterly misguided. In 1981, US private debt was 123 per cent of gross domestic product; by the third quarter of 2008, it was 290 per cent. In 1981, household debt was 48 per cent of GDP; in 2007, it was 100 per cent...
When interest rates fell in the early 1980s, borrowing jumped. The chances of igniting a [new] surge in borrowing now are close to zero. A recession caused by the central bank’s determination to squeeze out inflation [as in 1981] is quite different from one caused by excessive debt and collapsing net worth [like now]. In the former case, the central bank causes the recession. In the latter, it is trying hard to prevent it.
[My note: Here's another view of the data—it's no longer the Land of the Free.]
Thus the San Francisco Fed dryly concludes—
A simple model of household debt dynamics can
be used to project the path of the saving rate that is needed to push
the debt-to-income ratio down to 100% over the next 10 years--a
Japan-style de-leveragingsee note 2.
Assuming an effective nominal interest rate on existing household debt of 7%, a future nominal growth rate of disposable income of 5%, and that 80% of future saving is used for debt repayment, the household saving rate would need to rise from around 4% currently to 10% by the end of 2018. A rise in the saving rate of this magnitude would subtract about three-fourths of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change...
Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income [Event I, Figure 3]. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing. The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.
Really, this is almost all you need to know about the economic prognosis for the United States over the next decade. More precisely, it is 66-71% (= the private consumption part of GDP) of what you need to know. (Sans peak oil, which will make things worse, of course, but that's not my subject today.) That's the meat & potatoes. Let's talk about the gravy, i.e. the other 29-34% of the American economy as measured by GDP.
Piled Higher and Deeper
Please recall the formula (1) for calculating GDP. If private consumption PCE is down now and will be for some to come, and private investment I can't find a bottom, as the BEA data indicates, then growth is possible only if government spending G increases or exports gain relative to imports (Ex - Im). Thus Martin Wolf wrote back in February that—
... when the private sector tries to repay debt over many years, a country has three options: let the government do the borrowing; expand net exports; or let the economy collapse in a downward spiral of mass bankruptcy.
Assuming that a downward spiral of mass bankruptcy is not the preferred option, let's take a look at the trade balance (Figure 5) and government spending.
Figure 5— U.S. imports & exports from 1994 to the present from the ever-helpful Calculated Risk. The gap between imports and exports has narrowed, which adds to GDP. However, both are declining, albeit at a slower rate lately. There's not much help here for some years to come because our major trading partners (Europe, Japan) are even worse off than we are.
If the trade balance is not likely to boost output much in the next few years, we must look to government spending G for salvation. Many commentators, including Jim Jubak, noted that the second quarter's relatively small contraction was boosted by greater government spending. Our greater reliance on G to fuel growth is the reason why you hear so much talk about the size and timing of the Obama administration's economic stimulus package enacted last February. That is also the reason why you hear vociferous arguments over whether we need to further stimulate the economy.
It should go without saying that it will not be possible over the long run to replace past consumption fueled by inordinately large household debt with new consumption fueled by more public debt. The publicly held federal debt of the United States today is $7,330,489,761,535. Additional intra-governmental holdings debt is $4,318,058,383,034, which gives a grand total of $11,648,548,144,569. (I like to write the numbers out.) A trillion here, a trillion there, and pretty soon you're talking about real money. All current and future stimulus money must be borrowed, of course.
The interest expense to the government of all this debt is $320,650,178,293 so far in 2009, and amounted to $451,154,049,950 in fiscal year 2008. (These numbers are billions.) The creation of new debt to stimulate the economy is very inefficient. Not only must the government pay interest on the new debt, but, as Newsweek points out, it takes roughly $92,000 in government spending to create (or save) one new job!
So far, only a fraction of the stimulus funding has entered the economy via tax cuts ($43 billion), and another chunk via aid to state and local governments ($64 billion). Much of that, however, was used to avert cuts rather than to create jobs. New York City, for example, was able to avoid laying off 14,000 teachers. And because the contracting process is more complicated than it was in the 1930s, the investment component will take more time. So far, only about $120 billion in new spending has been promised to specific programs. Using a rough guide that $92,000 of government spending creates a job, the White House assumes the stimulus will preserve or create 1.5 million jobs by the fourth quarter of 2009 and another 3.5 million by the fourth quarter of next year. But the White House says less than 10 percent of the employment impact from the stimulus will take place during 2009.
[My note: I don't know if this $92,000 number counts the interest on this new debt or not. I doubt it.]
For a mere $92,000 one household is saved from ruin, at least for now. Presumably the new job recipient will pay taxes back into the system, and no longer requires unemployment insurance, so the government gets part of their investment back. But what about tax revenues generally? How are they doing? If you're going to run big deficits, you need big revenues too, either now or in the future.
Figure 6 — The percent change in tax receipts in descending order of decline for all 50 states and the United States as a whole. It's not looking good! Arizona is #1. See Arizona May Sell State Capitol Building To Balance Budget. State expenditures make up about 12% of GDP. One can guess how federal tax receipts are faring by looking at the states. The graph is from iTulip as cited in Figure 2.
We can add a new rule for governments (at all levels) to supplement the Saturday Night Live rule for households.
- Don't Fund Stuff With Future Tax Revenues You Will Not Collect
The threat to those still working is that desperate governments will be under pressure to raise taxes in future years despite a dead-in-the-water economy. The states, which received some stimulus help, are directly responsible for unemployment compensation, so the situation is dire. When things fall apart, they really do fall apart, don't they?
Most of the federal stimulus money will be spent in 2010, so it will add to GDP during that year. But it is worth repeating that private debt-financed consumption can not be replaced with debt-financed public spending for any length of time, especially in light of the fact that the consumption PCE and investment I components of output will be a drag on the economy for many years to come.
Gimmicks and Magic Tricks
It is hard to avoid the conclusion that the American economy is a flimsy house of cards. And if all you've got is a deck of cards precariously stacked thin end to thin end, you must continually resort to gimmicks and magic tricks to prevent it from falling down. Thus we get programs like cash for clunkers.
The Toyota Corolla has overtaken the Ford Focus as the top new vehicle purchased through the "cash for clunkers" program, the Department of Transportation said Wednesday. That means foreign automakers produce five of the six top-selling vehicles, although several of those, including the Camry, are built in the United States or Canada... Some Republicans have criticized the program as subsidizing sales for foreign manufacturers. To counter that, the Obama administration had touted that "cash for clunkers" buyers were choosing the Ford Focus more than any other vehicle...
The Toyota Corolla has overtaken the Ford Focus as the top new vehicle purchased through the "cash for clunkers" program, the Department of Transportation said Wednesday. That means foreign automakers produce five of the six top-selling vehicles, although several of those, including the Camry, are built in the United States or Canada...
Some Republicans have criticized the program as subsidizing sales for foreign manufacturers. To counter that, the Obama administration had touted that "cash for clunkers" buyers were choosing the Ford Focus more than any other vehicle...
I'm sure we still have a few excellent elected representatives in Congress, but I generally think of them (all together) as a bunch—I believe the word is "scurry"—of blind squirrels. And even blind squirrels find an acorn now and then. The Democrats believe they've found an edible nut in their "cash for clunkers" program, but it's just another gimmick, a magic-trick giveaway funded with borrowed money.
The "cash for clunkers" program provides an incentive for you to improve your vehicle's fuel efficiency, which is a good thing. Michael J. Jackson, chief executive of AutoNation Inc. called the program "an absolute success. There's a very compelling case the government should put more money into it. It's a great stimulus to the economy." But all the program really does is provide a limited-time incentive that temporarily moves future demand for cars forward.
When you don't have a real economy in which investment is based on real income and savings, gimmicks are all you've got left.
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1. The chart below compares oil prices to changes in the S&P 500. It's basically the same chart.
2. Japanese-style deleveraging comparing U.S. household debt/income (black line) and Japan's non-financial corporate loan debt/GDP (dashed line). Debt/income is expected to fall for the next 10 years.