The modern-day US economy has just gone through its most extraordinary period of wealth creation on record. First equities, then housing – over the past decade American households have added to net worth as never before. That binge is over. With the property market now cooling and equities settling in for an era of single-digit returns, wealth creation is likely to be subdued, for the foreseeable future. There can be no mistaking the profound implications of this development for the American consumer, the global economy, and world financial markets.
1997 was a year of great symbolic importance for the US economy. It was the first time in 30 years that household sector net worth moved back above its longer-term trend. And, of course, it was only the beginning of what we now know to have been the greatest surge of US wealth creation in the post-World War II era. There have been two major legs to this explosive surge in net worth. Reflecting a powerful equity bubble, real household sector net worth surged nearly 28% above trend by early 2000.
That was followed by a 16% pull-back in the aftermath of a wrenching post-equity bubble shakeout. But then, courtesy of the property bubble, a second leg kicked in – taking real household sector net worth up about 23% above trend as of early 2006. From bubble to bubble, US wealth creation broke the mold of anything seen in the past. Trend growth in real household sector net worth has averaged 5.5% since 1995 – more than 50% faster than average gains of about 3.5% over the prior 40 years.
The wealth effect: the US consumption boom
This wealth binge has reshaped the macro performance of the US and global economy over the past decade. First and foremost, it has fed a record American consumption boom. Initially driven by the largely psychological wealth effects of the equity bubble but then supported increasingly by the tangible proceeds of equity extraction from the property bubble, the US consumption share gapped up to a record 71% of GDP in early 2002 – well above the 67% norm of the prior 25 years.
Significantly, this consumption binge occurred in a climate of relatively weak income generation; over the 1995 to 2005 period, growth in real consumer expenditures outstripped gains in real disposable income by an average of 0.5 percentage point per year. This mismatch between income generation and consumption lies at the heart of the vanishing personal saving rate. When the surge in wealth creation began in early 1995, the personal saving rate stood at 5.7%. This same metric plunged into negative territory in 2005 – the first sub-zero reading since 1933 – and stood at a modern-era low of -1.5% as of the second quarter of 2006.
The rest of the story unfolds all too neatly. Reflecting the confluence of a negative personal saving rate and the government’s chronically large structural budget deficits, America’s overall domestic saving position also has plunged to record lows – a net national saving rate that averaged just 0.3% of national income in the four quarters ending 1Q06. Lacking in domestic saving, the United States then must import surplus saving from abroad in order to keep growing – and run massive current account and trade deficits to attract the foreign capital. In a weak climate of domestic income growth, that means the excesses of US consumption are being supported increasingly by foreign income generation. In other words, America’s wealth binge lies at the heart of the global imbalances that now pose such a serious threat to the stability of the world economy.
A slight digression is in order at this point. It has become fashionable in this era of froth to dismiss the US personal saving rate and current account deficit as nothing more than statistical anomalies – poorly measured and out of step with new developments in the financial economy. My advice: Don’t fall for these wild-eyed claims. They are just as misleading as the New Paradigm hype that filled your inboxes in the late 1990s. Trends in the government’s official estimate of the personal saving rate actually do a fine job in measuring disparities between growth rates of personal income and spending.
A negative saving rate does not necessarily mean that consumers have stopped saving; in the current climate, it simply implies that households have shifted the source of such saving from their paychecks to appreciation of their assets. I think that’s a perfectly reasonable way of interpreting the recent plunge in income-based measures of US saving. Similarly, if the current account deficit is such a figment of our imagination, why is the US running such a massive trade deficit? Why are foreign capital inflows still surging into dollar-denominated assets? The answer to both questions goes right to the core of a wealth-dependent society — a veritable lack of income-based saving.
The wealth effect: the US housing bubble
So much for what has happened. It is the prognosis that now matters most. I do not think there is any doubt that the US housing cycle is now turning. The questions pertain more to scope, speed, duration, and depth of the coming adjustments. In an era of financial-market deregulation -especially since deposit ceilings in mortgage lending institutions were eliminated by the early 1980s – residential property cycles have taken on a life of their own. As a result, both the uplegs and the downlegs have lasted far longer than standard business cycles. The data flow has certainly shifted to the downside – namely, mounting inventories of unsold homes, declining mortgage loan applications, rising financing costs, and anecdotal reports from builders and realtors.
A housing downturn will have obvious and important implications for US GDP growth. The direct effects are straightforward: Over the past three years, 2003-05, residential construction activity has boosted real GDP growth by about 0.5 percentage point per year. In data just released for 2Q06, the sector was estimated to have reduced annualized GDP growth by 0.4 percentage point. To the extent the decline in new building activity remains orderly, reductions could continue at the second quarter pace. Relative to the heady gains during the final stages of the boom, that means the contribution of residential construction activity could swing from +0.5% to -0.5% – imparting about a one percentage point drag on overall real GDP growth for at least the next couple of years.
The wealth effect: from stocks to property
The indirect effects are likely to be of greater consequence. In this case, it’s back to the saga of the wealth-dependent American consumer. And here it is very important to underscore the dramatic shift in the composition of the wealth effect that has occurred in the past six years. The first leg of the wealth binge was all about the stock market bubble; the equity share surged to a record 35% of total household sector assets by the end of 1999 – essentially double the portion of 1991. Reflecting the equity tilt to wealth creation, the residential property share of household assets fell to a postwar low of 24% in 1999.
The tables turned during the second leg of the wealth binge – the equity share collapsed by 15 percentage points during the post-bubble shakeout while the real estate portion regained lost ground and then surged to a new high. As a result, by the end of 2005, the market value of household sector residential property was nearly 50% higher than equity holdings. For wealth-dependent American consumers, that takes us to the main event: Barring a spontaneous and sustained resurgence of labor income generation – something I think is unlikely for as long as globalization and the global labor arbitrage persist – the state of the US property market could well hold the key to the consumption outlook.
Conventional wisdom has it that macro calls are hard to make in America’s diverse and highly fragmented property markets. “Local markets are subject to local conditions” became the mantra of real estate brokers and bubble-blowing central bankers, alike, over the past several years. In the early days of this housing bubble, that may have been an accurate assessment of market conditions. Not any longer. This bubble has gone to excess both in terms of scope and rate of expansion. As of the first quarter of 2006, the detail behind the widely followed OFHEO home price index revealed that in fully 53 metropolitan areas, house price inflation was still running at 20% or higher on a year-over-year basis. Nor are these areas America’s tiniest hamlets; making the list are places such as Phoenix, Miami, Los Angeles, and Washington, DC. Back-of-the-envelope calculations suggest that these 53 local markets collectively account for at least 50% of the total value of the nation’s housing stock.
Looking out over the next year, I fully expect the house price comparisons in most of the hottest metropolitan areas to be flat at best – and, quite conceivably, negative in many cases. That spells curtains for the heady pace of property-driven wealth creation that has powered the American consumer – and the global economy – in recent years.
The wealth effect: avoiding a hard landing
No, this does not represent another change in my thinking. The capitulation of the wealth-dependent American consumer has long been a central element of any realistic global rebalancing scenario. If once-frothy asset markets can no longer be counted on to backstop the American consumer, a reordering of saving priorities is both necessary and likely. Absent the support of asset markets, rational households will have little choice other than to return to income-based saving strategies.
The looming retirement of some 77 million baby boomers only underscores the imperatives of such a shift in the mix of saving. The result should be an upward adjustment to personal and national saving and a concomitant reduction in the demand for foreign saving — thereby tempering America’s need to run a massive current account deficit. Without such adjustments, you can forget about global rebalancing.
The trick will be to pull this off without a hard landing. Here’s where my newfound optimism comes into play. As long as G-7 finance ministers, the IMF, and the world’s major central banks remain committed to a rebalancing policy agenda, the odds favor more orderly adjustments in the US and global economy. A withdrawal of excess liquidity by bubble-prone central banks is a key element of this rebalancing agenda. The good news is that this process now appears to be getting under way. The bad news is that the authorities may have waited too long to begin the heavy lifting – leaving a still highly unbalanced world all too vulnerable to any number of exogenous shocks. Either way, there is no escaping the endgame. The wealth binge must be brought to an end if an unbalanced global economy is ever going to end up on safer footing. I think that is exactly what is now under way.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum