by Gary North
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.
There has 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 1995.
This means 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.
Stephen Roach 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 Recovery."
From the 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 recovery."
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.
This business 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 — or both.
It's a 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.
Notice that 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.
Lacking 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.
The Federal 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 in.
One factor 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.
This tells 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.
Price inflation 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.
I have 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.
Momentum 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 this waning.
Roach lists 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.
Myth #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).
It's not 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.
"Where 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."
Myth #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?
Roach is 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.
Let the 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.
The likelihood 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.
Indeed they 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 credit transactions.
Myth #3: 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.
I have 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. . . .
With oil 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 ending."
Myth #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.
No pun 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.
The personal 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.
The consumer 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.
Wages, however, are in a secular stagnation. Here, there seems to be no relief in sight.
Personal 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 than ever.
I agree. 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 ended.
Myth #5: 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.
Don't kid 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.
There has 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.
The persistence 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.
Call this synchronous non-recovery.
The slowdown 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 in recessions.
Thrift is 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.
August 14, 2004
Copyright © 2004 LewRockwell.com