The Aftermath of the Great Recession, Part I

The only function of economic forecasting is make astrology look respectable
   —John Kenneth Galbraith

There are two kinds of economists: those who can count and those who can't
   —old joke

Today's article is the first of a two-part series in which I attempt to forecast general economic conditions that will affect the oil market over the next 10 years. Despite Galbraith's sensible warning, what we will experience in the aftermath of the Great Recession is not a complete mystery. Strong evidence suggests that during the next decade, the global economy will struggle to regain a sound footing supporting vigorous growth.

This article and the next mirror closely what I will say at ASPO-USA's upcoming conference on October 10-13 in Denver, Colorado. I am moderating the "Great Recession and the Energy Markets" discussion. I will be joined by Eric Janszen, Adam Robinson, and author Kevin Phillips.

This is not necessarily the final version of my introductory remarks in Denver, but it is close enough. I am publishing these slides early to allow those attending the conference (or those who are not able to attend) to study the issues prior to the panel itself. There is probably more material here (and next week) than I will have time to present in Denver.

I can not cover the world in a short presentation. Therefore, most of my slides examine the economic prognosis for the United States and China. These countries can be viewed as a single entity called Chimerica.  By and large, a resurgence in economic growth outside Chimerica (e.g. in Japan, the Eurozone, the other BRICs) is unlikely unless both the U.S. (the world's largest economy) and China (the world's largest emerging economy) are prospering.

I believe substantial, perhaps overwhelming, evidence exists that points toward a protracted global downturn like that experienced in Japan during the 1990s (and beyond) following the crash of their stock market and real estate bubbles of the mid to late 1980s. The next slides lay out that case.

Overview

Figure 1 — The historical relationship between oil demand and global Gross Domestic Produce (GDP) since 1981. Year-over-year GDP/oil demand growth (percent). Source.

• Oil demand growth mirrors GDP growth, but is lower than GDP (percent-wise). The relationship varies over time.
• World oil demand has fallen for the last two years. The last time this happened was 1982-1983.
• Oil demand fell off ~2.8 million barrels-per-day at the economic bottom this time around.

Figure 2 — Two scenarios for oil demand from the IEA.

• In the bullish scenario, the world experiences a "V"-shaped recovery due to fiscal and monetary stimulus, but also "eventually" leads to the next oil price shock.
• In the bearish scenario, the downturn is protracted (a global "lost decade"). OECD demand has peaked and demand in the emerging economies (the BRIC countries, the Middle East) grows slowly, barely offsetting OECD declines.
• Those predicting a near-term (2010) oil price shock—roughly defined here as sustained prices > $100—must also be assuming a "V"-shaped recovery or a very rapid decline in the oil supply. There is at least 3 million barrels-per-day of spare capacity today, not all of which would be produced if demand spiked again to 2007 levels (Saudi Arabia).

Figure 3 — Relative sizes of the main world economies. The source is Menzie Chinn's How Important is China to World Growth?  The shaded area indicates the IMF forecast.

• Menzie Chinn's take on things: "Notice that indeed things are looking up in the BRICs (Brazil, Russia, India, China), with perhaps the exception of Russia. Or, more accurately, things are looking less bad in those countries. To keep things in perspective, 2008 US GDP (evaluated at market exchange rates) was about 23.5% of world GDP (all ratios from April 2009 IMF World Economic Outlook database), while these three economies in aggregate accounted for 54% of world GDP. The BRICs accounted for 14.6%. China is 7.3% of world GDP, so even with growth resuming, something else will be needed to get world growth back to near normal rates."
• Most of the rest of world GDP is in other OECD countries (e.g. South Korea, Canada, Mexico) or the Middle East.
• China's economy is only slightly larger than Japan's (as of 2008).
• Even 3-4% year-over-year GDP growth in the BRICs (taken together) starts from a relatively small base.
• Emerging economies tend to be dependent on exports with relatively small internal demand.

The Economic Outlook for the United States

It is said that prompt actions by the Fed & the Treasury last fall averted another Great Depression. We may have staved off a repeat of the cascading bank failures and deflation of 1929-1933, but we are left with something else that is perilous in its own way. It does not matter if you call it a "depression" or a "prolonged downturn" or something else.

Economist Richard Koo calls this a balance sheet recession to distinguish it from "normal" recessions in which consumption picks up quickly from where it left off prior to the downturn. (And look here for Koo's technical overview.)

Figure 4 — Real household debt, wealth and income 1960-2008 from the San Francisco Fed's U.S. Household Deleveraging and Future Consumption Growth. See my Don't Buy Stuff You Can Not Afford for more details.

• The trend is established from 1960 to 1983. Real household debt and housing wealth followed the real income line.
• In 1983, household debt, supported by rising stock wealth, decouples from real income (Event I).
• In 1997, housing wealth decouples from real income (Event II).
• The two bubble tops are shown (light gray circles). The Web/Tech Bubble burst in March, 2000. The Housing Bubble collapsed in mid-2006.
• The entire period 1983-2007 can be thought of as a Credit Bubble supporting debt-based personal consumption (vertical bars, key lower right). The savings rate fell to zero by 2005-2006.
• Now we enter the long period in which households and banks must repair their balance sheets. But it is much harder to pay off debt while asset values fall (dotted red line and the real stock wealth line).
• One "solution"—the "solution" preferred by the Treasury & the Fed?—is to inflate our way out of the debt.
• The future of real income is in doubt. High unemployment puts downward pressure on income, and we've just had a decade (1998-2008) with no income gains. Perhaps real income has nowhere to go but down from here on out.

All of this spells real trouble for the consumption (PCE) part of GDP. GDP is calculated by the formula—

• Gross Domestic Product = PCE + I + G + (Ex - Im)
  where PCE = personal consumption expenditures, I = fixed investment, G = government expenditures and (Ex - Im) = exports minus imports

In recent years, personal consumption has accounted for nearly 70% of total U.S. GDP. That massive debt-fueled consumption drove the global economic boom of recent years, and thus the oil demand shock of 2003-2007.

One obvious consequence is that GDP growth in the U.S. was financed by ever-larger debt and two catastrophic bubbles. The Tech bubble led to a large loss of stock market wealth but gave us the internet and a powerful telecommunications infrastructure. The much larger Housing Bubble led to a disastrous misallocation of capital with no apparent upside.

The future of personal consumption in America looks bleak.

Figure 5 — The history of personal consumption in the United States since 1994, year-over-year change in billions of dollars. From iTulip's August 2009 FIRE Economy Depression - Part I, Snowball in Summer.

• You can see that consumption peaked right before the Great Recession began in December, 2007 has fallen dramatically since.
• What would support large consumption increases matching pre-2008 levels going forward? It is hard—well-nigh impossible—to find any good news in that area, to wit—
• Unemployment will be high for a long time to come (See Figure 6 below).
• The Boomer spending spree is over. They start retiring in 2011. See my The Incredible Shrinking Boomer Economy (See Figure 7 below.)
• There is greater wealth inequality in the United States than any time since 1928. The Middle Class now carries most of the household debt. See my The New Gilded Age. (See Figure 8 below.) The income share of the bottom 90% of people in the U.S. stood at 50% in 2007, down from about 67% in the 1960s and early 1970s.
• During the bubbles, people felt rich. In the absence of new bubbles, the loss of wealth (in stocks, housing) combined with a shaky job market will dampen consumption for many years to come.

Figure 6 — From the San Francisco Fed's Jobless Recovery Redux? See my Bad Signs, New Bubbles for details.

• This chart shows projections for the "official" joblessness rate, which now stands at 9.7%.
• The U6 number is said to be 16.8%. This number counts all the unemployed, including those who have stopped looking for work, and all the underemployed, which includes all those who have accepted involuntary cutbacks in their hours worked.
• The Bureau of Labor statistics has understated all the numbers because of adjustments made via their bogus birth/death model for businesses.
• A prolonged "jobless" recovery is the most likely scenario.

Figure 7 — Personal consumption with and without health care spending as a percent of GDP since 1960. From Calculated Risk's Health Care Spending and PCE.

• Health care spending has been growing as a percentage of GDP since the early 1980s. (Remember, all this time GDP was growing and so was consumption, but growth in health care expenditures rose faster than all other consumption.)
• As the Boomers retire, health care spending will go up & up but ex-health consumption will not. Health care costs will soar unless effective reform is implemented.
• Medicare & Medicaid spending is counted as personal consumption (PCE) in GDP calculations.
• So health care spending will add to GDP, but much of that money will be spent to support the medical needs of an aging population.
• As health care rises rapidly as a percent of GDP, the rest of the real economy (ex-health) may actually be shrinking (depending on the overall rate of growth). This continuing imbalance makes it more and more difficult for the dwindling working population to support the aging Boomers.

Figure 8 — The overleveraged Middle Class in America, from a Bank of America Merrill Lynch report, and reprinted by Zero Hedge in A Detailed Look at the Stratified Consumer.

• In the left panel, you can see the debt-to-income (left) and the debt-to-assets (right) ratios. In the right panel, you can see that Middle Class borrowing soared during the Housing Bubble.
• People thought house values would never go down. They felt rich, so spending was supported by imaginary equity in residential real estate. (All bubbles must crash, what goes up must come down.)
• This was the time when the Middle Class used their homes as ATM machines by taking home equity loans or second mortgages, or extracting cash from equity by refinancing.
• Housing prices have crashed and won't come back for a long, long time.

Figure 9 — Mortgage debt (blue lines) versus equity (red line) from 1945 to the present, taken from T2 Partners’ More Mortgage Meltdown.

• More than 15.2 million U.S. mortgages, or 32.2% of all mortgaged properties, were in a negative-equity position (underwater) on June 30, edging down from 32.5% at the end of March. Negative equity is when you owe more on your house than you can sell it for.
• 13.2% of all mortgage loans were in foreclosure or delinquent as of the last Mortgage Bankers Association survey. Foreclosures or delinquencies now threaten prime mortgages
• There has been a dramatic decrease in cure rates for delinquent mortgage loans. Delinquency cure rates refer to the percentage of delinquent loans returning to a current payment status each month. Cure rates have declined from an average of 45% during 2000-2006 to the current level of 6.6%.
• House prices have probably not bottomed out yet according to Calculated Risk.
• All this spells big trouble for small or medium-sized banks holding these loans.(Fannie Mae, Freddie Mac an banks that are "too big to fail" will be bailed out.)

Figure 10 — Total real estate debt held in the United State from Rolfe Winkler's America's Japanese Banks.

• Banks have $4.656 trillion dollars in loans outstanding in residential and commercial real estate (yellow line in Figure 10).
• Residential real estate has been crashing since 2006, and commercial real estate—a lagging indicator—is crashing now. This is the dreaded "second wave" of defaults.
• Commercial real estate, valued at some $3.5 trillion, has experienced a 39 percent decline in prices from the peak only two years ago, according to the MIT Center for Real Estate. The 18 percent price decline in second quarter was the largest quarterly drop in the 25 years since MIT first published the commercial real estate price index.
• As asset values fall, banks become insolvent. We can expect approximately 1000 small and medium-sized banks to fail in the next two years.

By saving Fannie Mae, Freddie Mac, "too big-to fail" banks like Bank of America, and Wall Street, (i.e. the credit system), the Fed & the Treasury did not also save over-leveraged American consumers. We have probably reached "peak credit" now, and demand for credit will be down for some time to come as households struggle to save and pay off debt.

The Fed & the Treasury have been fighting the wrong battle in the last war. Their wacky assumption has been that we can have endless economic growth based on endless debt. The idea that reviving the credit markets (via the bail-outs) would lead to a quick turnaround (a "V"-shaped recovery) is just plain wrong. Both Ben Bernanke and the San Francisco Fed's Janet Yellen now acknowledge the new reality. Up until fairly recently, the Fed Chairman was in denial.

That's enough grim news for today.

Next week I will publish Part II, including U.S. government deficits, the U.S. balance of trade, China and a summary of the situation.

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