In we accept
the widely accepted assessment of the non-profit National Bureau
of Economic Research, and we date the recession as having begun
in March, 2001, and having ended the following November, then
we are approaching three years of America’s economic recovery.
been a recovery of sorts. Manufacturing is up, surely. But wages
adjusted for price inflation have been stagnant or worse. Interest
rates are low, which is good for borrowers and bad for savers.
Unemployment is still around 5.5%, which is on the high side.
This figure keeps getting revised. Job growth is slow, and has
remained slow throughout the entire period.
This is a
strange recovery. Housing prices never stabilized, let alone dropped.
Consumer spending did not drop, nor did consumer indebtedness.
The figure I return to over and over is "Household
Debt Service and Financial Obligations Ratios." This
compares what households are paying on their debt each quarter
in relation to disposable personal income. For homeowners over
the last quarter century, this figure has rarely gone below 13.5%
or above 16%. In fact, the only time it exceeded 16% was in the
4th quarter of 2001 — the end of the recession.
It is in the range of 15.5% today. It has not been below 15% since
that consumers have used lower interest rates since 2001 to add
marginally to their total debt. Their ratio of monthly debt payments
in relation to their income has dropped slightly, but not nearly
so far as interest rates have fallen. So, Americans have taken
advantage of lenders. They have said, "I’ll take that money!"
Rising rates therefore pose a threat to them. Their debt is higher;
their debt service expenses will rise. This will put pressure
on their budgets. They will slow their spending in order to keep
debt service below 16% of their disposable income. When this happens,
the recovery will sag.
of Morgan Stanley is a sensible commentator. I have seen him quoted
in the financial press for many years. He always impresses me
as someone who is not bowled over by the media trend-setters.
In his August
9 column, which is posted on the Morgan Stanley Website, Roach
called attention to the oddities of this recovery. The article
is up front: "The Mythical
start — presumably, late 2001 — this recovery has been
dubious, he says. "Now that the major equity market indexes
have all hit new lows for the year, there will undoubtedly be
a rush of buy recommendations from that same optimistic consensus.
My advice: Look before you leap at the siren song of the mythical
What is his
gripe with the consensus view of the recovery? Mainly, that this
recovery has been like no other in the post-war era.
cycle is different. The modern-day US economy has never had
to struggle this hard to eke out an economic recovery. Plagued
by an outsize shortfall of internal income generation, it has
taken an unprecedented dose of fiscal and monetary stimulus
to spark any semblance of cyclical revival. But the question
all along has been, recovery at what cost?
This is always
the economist’s favorite question: "At what cost?" It
ought to be the investor’s question, too. You would think that
it is the fund managers’ question. But fund managers run in packs.
They don’t ask this question until costs start exceeding benefits
by a painful margin: a falling stock market or bond market —
cost, in my view, that has been manifested in the form of an
extraordinary array of imbalances — record twin deficits
(budget and current account), a massive household sector debt
overhang, an unprecedented shortfall of domestic saving, and
an asset-dependent support to aggregate demand.
these imbalances are all debt-related. People are spending what
they have borrowed, and they are saving less than normal. But
wait. If someone is borrowing, then someone else is saving. The
problem is, the savers have not been Americans. They have been
foreigners who have extended credit to Americans. In addition,
Roach says, the Federal Reserve System has been creating money
at a high rate, and the U.S. government has been running a huge
deficit: fiscal stimulus.
in the organic staying power of job creation and wage earnings,
the US economy has become addicted to the steroids of extraordinary
monetary and fiscal support. But with policy levers pushed to
the max, the lifeline of support is now dangerously thin. For
such an unbalanced and vulnerable economy, it doesn’t take much
of a shock to put a low-quality recovery in trouble. As bad
luck would have it, that’s precisely the risk as oil has once
again entered the macro equation.
Reserve announced a quarter percentage point increase in the federal
funds rate — the rate that banks lend money to other banks
overnight — the shortest of short-term rates. The FED is
sending a message that it is marginally concerned with inflation.
Or is it?
Is it sending any message other than this one: "We will adjust
to the new conditions of supply and demand for loans"?
If the stock
market’s recent performance is any indication, smart money is
becoming convinced that there is greater risk in equities than
in low-interest debt. Lenders are moving out of stocks and into
the credit markets. They are even lending short-term at negative
rates, or close to it, after price inflation and taxes are factored
that is continuing to put downward pressure on short-term rates
is the Federal Reserve System. The adjusted
monetary base has moved up dramatically in recent weeks. It
is now in the 10% range.
me that the FED is not worrying about inflation. It is determined
to keep the recovery going, for whatever that’s worth. It is going
to make credit available.
is a growing consideration. Last year’s chatter about imminent
deflation has gone away. As you know, I never believed it —
not in 1974, 1982, or last year. I use the Median
CPI figure, published by the Cleveland Federal Reserve Bank.
As of June, the rate of increase was 0.2%, which is a 2.2% annual
rate. It was up 2.5% over the last 12 months. This is lower than
the CPI, which is rising by almost 4% at an annual rate. The CPI
gets more publicity.
held this dour view for about five years — since 2000,
to be precise. My basic concern was that America’s post-bubble
carnage would take a lasting toll on the recovery dynamic. An
accelerated pace of globalization and the related pressures
of what I have called the global labor arbitrage only intensified
my concerns. This view served me well for the first four years
of America’s post-bubble workout but didn’t work all that well
over the four-quarter period from 2Q03 through 2Q04, when real
GDP growth averaged 5.1%. But now with momentum on the wane
again, it pays to ponder the downside.
does appear to be waning, both in the overall economy and the
stock market. It is not just the price of oil that is causing
five myths that are commonly invoked to defend the idea of a continuing
recovery. He does not believe any of them. Neither do I, but I
disbelieve some of them for reasons different from his.
#1: The US economy has achieved the critical mass of a self-sustaining
cyclical recovery. The theory is very straight-forward: Jobless
recoveries don’t generate enough income to drive consumer demand.
Counter-cyclical policy stimulus — fiscal as well as monetary
— can fill the void, sparking an inventory and production
dynamic that spurs income and spending growth. From there, the
"multipliers" take over, and the self-sustaining recovery
can then successfully be weaned from policy stimulus. It’s a good
theory but it’s not working.
On the contrary,
it’s a bad theory, and it has never worked. It is the Keynesian
theory, which was dominant in academic circles from the 1940s
through the 1970s. It was as wrong in 1936 as it is today. A dollar
spent by the government to "get the pump primed" is
either a dollar borrowed (not used by the lender — no multiplier),
a dollar taxed (not spent by the taxpayer — no multiplier)
or a dollar created by the FED (a multiplier whose effect is to
raise prices and thereby lower real wages, which was the dirty
little secret of Keynes’ theory: a way to fool workers into accepting
lower wages, which they needed to do, but the government/union
alliance would not allow them to do, during the Great Depression).
just that job creation has averaged an anemic 55,000 per month
over June and July. It’s that this recovery has been accompanied
by the weakest employment profile on record. In only three of
the 32 months of this recovery has job growth exceeded 200,000;
by contrast, in looking at the average profile of the past six
cycles, that threshold was exceeded 14 times over the comparable
32-month time frame. By our calculations, private nonfarm payrolls
are currently 8.1 million workers below the path of the typical
hiring-led recovery. Lacking in job creation, real wage and
salary disbursements — the key organic driver of household
purchasing power — are running $323 billion below the typical
recovery profile. All this speaks of the absence of the critical
mass for self-sustaining recovery.
are the jobs?" This is the question that the Democrats keep
asking and the Republicans have not answered. The correct answer
is: "The jobs are there, at some wage, but government restrictions
on the labor markets and businesses, coupled with tax-funded unemployment
insurance, have kept employers and employees from coming to an
agreement." If that sounds like my answer for the Great Depression,
you understand economics. Does someone want a job? He can get
one: "At some wage."
#2: Imbalances don’t matter. Few can deny the severity of America’s
imbalances — a 5.1% current account deficit, a 4% federal
budget deficit, a sub-2% net national saving rate, and household
sector indebtedness that now exceeds 85% of GDP. Where the denial
creeps in is with respect to the implications of these imbalances.
America is special, goes the logic. The rest of the world is desperate
for high-return dollar-denominated assets in the world’s most
productive economy. That makes current-account and budget deficits
a cinch to finance. Debt isn’t a problem because interest rates
are still low — at least for the moment. And who needs old
fashioned income-based saving, when ever-rising asset markets
will do the job?
parroting the standard line of most economists. He doesn’t believe
it. Neither do I. Here’s why I don’t believe it. Asian central
banks have been driven by a desire to subsidize their nations’
export markets by holding down the price of their currencies in
relation to the dollar. These central banks have been funding
the current accounts deficit. But this has now stopped, according
to most public statistics.
record show that that the personal saving rate fell back to
a rock-bottom 1.2% in June 2004. Lacking a cushion of income-based
saving, over-extended and asset-dependent American consumers
suddenly have their backs against the wall.
I don’t believe
this — not yet. I have already explained why. Household debt
repayment is not in crisis mode. But when rates rise, the consumer
will find himself hedged in.
of a saving-short US economy continuing to run ever-wider current
account deficits without suffering dollar and/or real interest
rate consequences is close to zero, in my view. Imbalances matter
— now more than ever.
do. But they keep getting larger, yet interest rates stay low.
Lenders and borrowers are still saying, "It’s business as
usual." There is no sense of urgency on either side of these
Oil doesn’t matter. Every time oil prices go up, we are always
subjected to the same dismissive cop-out: Since the energy efficiency
of US GDP has continued to improve, the role of oil in shaping
both production and consumption has steadily diminished. As
such, the impact of a given increment in oil prices is not what
it used to be. So don’t worry.
never bought this one either. The record is pretty clear on
this risk factor: Each of the five recessions since the early
1970s has been preceded by an oil shock in one form or another.
The key question, in this instance, is whether the US has experienced
a true oil shock. I have previously argued that while $40 oil
hurts, it does not qualify as a full-blown shock; however, relative
to the post-2000 average of $29 per barrel, a $50 price tag
would have to be considered a shock. . . .
at $45, we are getting close to the shock zone, he says. Well,
maybe. But oil was at $80 a barrel in today’s money back in 1980.
We are still a long way from that level of shock. I see the effect
as more of a grinding down of people’s disposable income. It’s
headed in the wrong direction. It is saying, "The party is
#4: Nothing stops the American consumer. This is widely perceived
to be the Golden Age of US consumption. Recent trends add a good
deal of credence to this presumption. Over the eight-year period,
1996 to 2003, real consumption expenditures rose at a 3.9% average
annual rate — well in excess of the 3.3% pace of real GDP
growth over the same period. Nor did the consumer flinch in the
aftermath of the burst equity bubble in early 2000. Lacking in
income, consumers have become increasingly creative in levering
their balance sheets and extracting purchasing power from assets
in order to keep the magic alive. Most believe that this creativity
remains an enduring feature of our times.
This is true,
but the consumer’s ability to pay off his debts every month indicates
that things are not at a crisis level yet. Unless interest rates
rise sharply, most people are going to do next month what they
are doing this month.
intended, but I continue to worry that the American consumer
is living on borrowed time. Yes, debt is a key concern. Even
with interest rates near 40-year lows, debt service burdens
— interest expenses relative to disposable personal income
— are near historical highs.
This is true,
but the ratio of debt burden to disposable income has been at
this level ever since 1995. The worst was in 2001. This is not
to say that economic pressure on this ratio will not cause consumers
to cut back. They will cut back. They will have no choice. But
it will take sharply rising interest rates to do this.
saving rate, as noted above, is near historical lows. Wage income
generation, also as noted above, is lagging as never before.
And, as the US property cycle nears its secular peak, asset-driven
consumption strategies will be challenged as never before. All
this speaks of a US consumer that is lacking in staying power
and therefore vulnerable to the slightest of shocks.
is vulnerable. But he has been vulnerable for a decade. The savings
rate has been low since that time. Yet the 1995-2000 period was
the bubble phase of the NASDAQ, and a time of "irrational
exuberance" for the S&P 500.
are in a secular stagnation. Here, there seems to be no relief
consumption expenditures rose at only a 1% annual rate in 2Q04
— one-fourth the post-1995 trend and equaling the weakest
quarterly increase since 1Q95. I have long been wary of betting
against the American consumer. That bet is now more tempting
I think the setback has already begun. The squeeze is on —
not a crisis-level squeeze but a "party’s ending" kind
of squeeze. The reality of the stock market has begun to affect
people’s perception of their economic future. The bonanza has
The world is now on the cusp of synchronous recovery in the
global economy. The hope here, of course, is that an unbalanced
US-centric world has now been rebalanced, thereby providing
the global economy with a broader platform of support. That,
of course, would come in quite handy in the event of a shortfall
in the US economy. On the surface, a broadening out of the global
growth dynamic offers encouragement in this regard — underscored
by our estimates of 5% growth in the Japanese economy in 2004,
6.4% in Asia ex-Japan, and 4.7% in Latin America. Even in Europe,
we have raised our sights recently to 2.1% in 2004.
yourself. The world, in my view, remains very much a two-engine
economy — the US consumer on the demand side and the Chinese
producer on the supply side. The American consumer, as just
noted, is already on thin ice. And the Chinese producer is now
being hit with a sharp blast of policy austerity in an effort
to tame the excesses of a severely overheated economy. One lesson
I have learned over the past decade is that it pays to heed
the wishes of the Chinese leadership.
As to the
Chinese government’s policy of austerity, I will believe it when
I see China’s money supply go to single-digits. Until then, I
am going to watch what the central bank does, not what Communist
politicians say. Money talks — even fiat money.
been a slowing in the rate of China’s money growth, from over
21%, year to year, mid-2002 to mid-2003, to less
than 18% this year, mid-2003 to the present. This
indicates that the government is ready to risk a soft landing.
But I would not call this an austerity plan.
of massive external imbalances in the global economy speaks
of a non-US world that has failed to develop autonomous sources
of domestic private consumption growth. Lacking in new growth
engines, weakness in the US and China should put to rest the
myth of a new synchronous recovery in the global economy.
is in the pipeline: the oil pipeline and the Chinese money supply
pipeline. I do not see a shock, but I see a grudging awareness
by American consumers that they are stretched, if not to the limit,
then at least to the point of discomfort.
If the new
car market stumbles next month and in October, as I think it will,
we will have evidence of a slowing economy. We will have this
evidence by the November election.
The big problem
is the low rate of domestic savings. We have seen a fundamental
change in Americans’ attitude toward the necessity of thrift.
This did not change in the recession of 2001, as it usually does
the source of capital. It is the source of future productivity
and income. It reveals an attitude toward the future. It is a
mark of self-government and personal responsibility. Until this
figure triples, I will remain skeptical regarding the fulfillment
of what we like to call the American dream.