Due to higher inflation, higher short-term rates and compound interest, ever-increasing amounts of credit are required to maintain their effects on spending and asset prices. Signs of a slowing global economy are abounding, led everywhere by the manufacturing sector. Downward surprises are chronic. The US economy is no exception.
Our highly critical assessment of the US economy is mainly determined by two extremely negative considerations. First, its chronic structural imbalances between consumption, saving, investment and debt creation have dramatically worsened since 2000; and second, both monetary and fiscal policies have virtually exhausted their stimulatory potential. There is little or nothing left for them to do when the economy slides back into recession.
It is the particular feature of US economic growth, since the late 1990s, that consumer spending has increasingly outpaced the growth of production. Its counterparts are a collapse in saving out of current income, weak business fixed investment and the soaring trade deficit. Actually, business borrowing goes mostly into mergers, acquisitions and dividend payments.
The most striking hallmark of this escalating divergence between consumption and output in the US economy has been the exploding US current account deficit, presently running at an annual rate of close to $800 billion. This is more than six times the $109.5 billion recorded in 1995.
It seems that policymakers and economists have yet to realise that this deficit is the economy’s great income and profit killer. To offset the implicit huge drag on domestic production, employment and incomes, the Federal Reserve has kept its money and credit spigots wide open to create alternative domestic demand.
In his congressional testimony on June 9, 2005, Federal Reserve Chairman Alan Greenspan described the US economic situation to be ‘on a reasonably firm footing.’ Looking at monthly figures from the Bureau of Economic Analysis’ (BEA) Personal Income and Outlays report, we note a dramatic deterioration in income growth and spending growth.
These figures find very little attention. In reality, they are of eminent importance because they show changes in consumer incomes and spending on a monthly basis. Given the high share of consumption in GDP, it is the best proxy for current GDP growth. For the first two months of the second quarter, April to May, consumption is up 1.2% at annual rate.
The published numbers for the gains in real disposable income are actually so disastrous that we hesitate to take them at face value. Real disposable income in May 2005 was $8,211.6 billion, down sharply from $8,473 billion in December 2004. Assuming a big distortion from December to January, we focus on the four months February to May. Over this period, the real disposable income of private US households edged up a miserable $37.7 billion, equal to an annual growth rate of 1.5%. For comparison, real disposable income grew 3.7% in 2004 and 2.3% in 2003. It seems reasonable to describe this as an income collapse.
Over the same four months, consumer spending in chained dollars surged by $75.7 billion, but with a steep downtrend: February, $32 billion; March $28.6 billion; April, $18.1 billion; May, $3 billion.
There is no secret as to how the American consumer has been pulling this off. It is all about an economy in which demand growth through income creation has been increasingly replaced by inflating asset prices providing the collateral for ever-higher spending on credit. But income creation is not catching up; it is in dramatic decline.
We are looking for the deeper macroeconomic causes behind this rapidly widening gap between consumer spending and consumer incomes. These reside in the two major structural imbalances, which policymakers and economists in the United States stubbornly refuse to regard as a problem.
The paramount reason is the soaring deficit in the US economy’s current account, reported at $195 billion for the first quarter of 2005. This sum reflects current spending of many different kinds in the United States. The recipients of this huge amount, however, are foreigners enjoying a corresponding rise in their current incomes. These big income gains on the part of the surplus countries implicitly have their counterpart in a commensurately big income leakage on the part of the deficit economy. With its soaring current account deficit now close to $800 billion, or well over 6% of GDP, the US would long be in deep recession.
To offset this enormous trade-related income drag cogently requires compensating credit and debt creation to generate alternative demand. That is what the Fed has done with its persistent extreme monetary looseness. Thus the monstrous trade deficit has trapped the US economy in a vicious circle of growing credit excess.
But as the demand for manufactured goods is increasingly met by foreign producers, the alternate domestic credit creation increasingly feeds service jobs, of which a large number are low-paying. Another point to consider is that different types of expenditures have very different after-effects. Just compare in this respect the difference in income creation between spending for health service and spending for building a new factory. In short, easy money replaces the good jobs that emigrate by bad service jobs.
In our view, gross lack of investment spending with high multiplier effects is America’s second biggest macroeconomic deficiency.
In line with Austrian theory, we regard capital spending as the critical mass in the capitalist process, generating all the things that make for true prosperity. First of all, it creates employment, income and tangible wealth from the demand side while the plant and equipment are produced. Then, upon their instalment, all these capital goods create employment, productivity and income from the supply side.
And there is still a third point to be considered. First, capital investment is self-financing; and second, depreciations and their reinvestment create an endless stream of recurrent employment and income without any additions to debt. Investment-driven economic growth, therefore, has a very low debt propensity. In contrast, unproductive government and consumer debt automatically feed on themselves through compound interest.
There was a drastic break in the US economy’s debt propensity from the early 1980s, similar to the late 1920s, but considerably worse. In both cases, it had the same two causes: booming consumption and financial speculation.
Again, we emphasise that the US economy’s prospects is presently the all-important question for the global economy. The popular spin, trumpeted by Mr Greenspan in particular, is that the US economy possesses such extraordinary resilience and flexibility ‘that its imbalances are likely to be adjusted well before they become potentially destabilising.’
It is an absurd statement; because flexibility is the last thing the US economy has shown in the past few years. Its one and only flexibility has been in the creation of a housing bubble and the associated credit bubble, while all the structural imbalances – rock- bottom savings, asset inflation and the monstrous trade deficit – have soared to new extremes.
Duly, the US pattern of the economy’s downturn in 2000- 01 has diametrically differed from the typical, cyclical kind. All past recessions were triggered by monetary tightening, the Fed’s response to rising inflation rates. Consistent with tight credit, consumers and businesses slashed their credit-financed expenditures. These were the same components in all economic downturns – consumer durables, business investment and residential building.
This downturn has been unlike anything ever experienced in the annals of the business cycle. While the Fed undid its 1998 rate cuts in the first half of 2000 – raising its federal funds rate in three steps by a total of 1%, to 6.5% – credit flows to businesses and consumers escalated as never before. Yet real GDP growth slowed sharply from 3.7% in 2000 to 0.8% in 2001. It was the first recession to happen under conditions of rampant credit expansion.
But what distinguished the 2001 recession most radically from all past experience was its pattern. The downturn had centred on one single demand component – business fixed investment. With a plunge of 13.1% in 2001-02, it experienced its sharpest fall of all postwar business cycles. In an equally unusual fashion, consumer spending simultaneously surged by 5.8%. Clearly, the extraordinary developing consumer borrowing-and-spending binge moderated the economy’s downturn.
The following recovery has been just as diametrically different from past experience. With the lowest interest rates in half a century and the biggest fiscal stimulus in history, the US economy’s recovery from its 2001 low has nevertheless been its weakest by far in the whole postwar period by any measure. The broadest popular measure is real GDP growth. It increased during the three years 2001-04 by 9.6%, as against an average of 14% growth over the same period for previous cyclical recoveries in the postwar period.
But there is a second utterly unusual feature in this US economic recovery. Just as in the case of the prior downturn, its pattern differs diametrically from past experience. The normal V-shaped recovery remains grossly missing.
Three aggregates of crucial importance for sustained strong economic growth show persistent, drastic shortfalls. These are business fixed investment, employment and real wage and salary income. It should be clear that a recovery’s composition crucially matters for its vigour and sustainability.
Typically, past cyclical recoveries got their immediate, strong traction from pent-up demand for business fixed investment, consumer durables and housing generated by the prior tight money. This time, two critical components went badly wrong: Business fixed investment recovered meekly, and foreign trade went into an exploding deficit.
This US economic recovery has been unique in that it rests on one single pillar – the housing bubble, which the Fed systematically engineered to boost consumer spending through easy consumer borrowing against rising house prices. Ominously, this is occurring against the backdrop of unusual weakness in the growth of employment and wage and salary incomeBy Dr Kurt Richebächefor The Daily Reckoning
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