Themes For 2010 - 3 - The Economy

For last week's discussion of the credit markets click here. In it we discussed the state of the existing credit base as well as the supply/demand equation for new credit and refinancings. In both cases, we found that credit was contracting significantly - even while government encouragement of accounting shenanigans has been allowing financial institutions to value their assets at [essentially] whatever they want.

Today, we turn our attention to how this above state of affairs is going affect the US and Global economy as a whole.

To calculate the GDP of a nation, most feel a fairly simple equation can be made: GDP = C + I + G + (E -M). Private Consumption, Gross Investment, Government Spending and Exports less Imports.

I'm not a particular fan of this metric. First, because essentially any activity, no matter how wasteful, counts as a net positive toward "economic activity." As a result, we are encouraged by government to undertake all sorts of wastefulness in order to keep up the appearance of prosperity. Second, economic activity which has been financed by debt counts just as much as does that financed by savings. All sorts of malinvestments result from crazy debt ponzi schemes. Should this really be considered "growth"? Third, GDP is too aggregative for my liking. It does not tell me enough about which part of the structure of production economic activity is being directed toward. Is money being spent on raw materials for the use of a factory owner who wants higher quality/more durable products? Or is it being spent by the military for the construction of bombs? The use of each have directly opposite impacts on our overall wealth, once the materials are used. GDP does not distinguish.

Return on our investments and the overall wealth of our society is what most readers here are concerned with, not some nebulous GDP number. So for our purposes, we will try to delve deeper into the various components of GDP for clues as to whether our overall prosperity will be on the rise, or will contract further.

It should also be noted that there is a wide theoretical disagreement on the cause of the current recession. Most of economic orthodoxy believes that an economy is always at equilibrium. There is no such thing as "growing imbalances" to worry about. This way, they can turn the entire economy into a mathematical model and determine the correct inputs and functions to predict the future. When the crisis erupted in 2008, plunging asset prices completely discredited this mathematical approach to economics. But the neoclassical economists have useful little terms like "rogue waves" and "tail risk" to explain crises. According to them, this completely random wave is what hit the economy in 2008. Nobody could have predicted it. It also necessarily follows that because this was just some irrational exogenous shock, now that it is over we should experience a rebound back to "trend growth"

While this is the orthodoxy subscribed to by many, there are literally thousands of economists who think it is total lunacy. Many of these economists instead choose to pay attention to debt levels and their effects on the economy, or the endogenous nature of recurrent financial crises in all economies. They focus on demographics, international trade and changing social preferences. The predictive record of these economists has been orders of magnitude better than the neoclassical economists and their mathematical models. Other than cognitive dissonance, it behooves me why one would continue to ignore the former in favour of the latter.

Before I bore you to tears, let me get started.

The Consumer

It is no secret that the consumer's large impact on the direction of the economy has, in part, been influenced by the easy availability of credit as well as a social incentive to go into debt for the purchase of material goods. Last week, we saw consumer credit numbers for November. Total credit outstanding continues to contract at increasing rates. It should be clear that this is a secular trend, after hardly dropping much below zero in the postwar period. Consumer attitudes toward debt have clearly changed. And we should be careful to assume that discretionary consumer spending will lead the economy out of recession as it typically has. This is not a typical recession, where producers overproduce, causing supply gluts, affecting employment, prices, etc. The cause is credit based. Too much of it. So while the cause was different than most recessions, the cure will also be different. Below is a chart of consumer credit outstanding. It contracted a further $17.5 billion in November - a new record rate of decline.



Of course, not all of America's consumption growth has been based on credit growth. Much of it has been based on genuine income growth. But that income growth has been falling of late as well. See below, the decreasing income and sales taxes collected.



Both real incomes and consumer credit have been deflating. This bodes ill for future consumption. Most would consider this a bad thing. But, as we can see in the chart below, the US (and much of the West) have been consuming more than they produce for a long time. So long, that we have gotten used to it. Over time, consumption must equal production. And it appears that truism is finally playing out.



(chart from Jake at EconomPic Data)

He explains,

The difference between GDP (what the U.S. produces) and Gross Domestic Purchases (what the U.S. purchases) is net exports. Thus, the charting is easy, but the result of the chart is rather astounding. The net level of purchases over production peaked at more than $2500 per person (that is literally $2500+ in a single year for every man, woman, and child within the U.S.) in September '06. This has "collapsed" to "only" $1150 a head, but that $1350 less that each person in the U.S. has been able to purchase (without producing) is a real decline.

So where does that leave us? It leaves us with entire generations (starting with the baby boomers) that believe it is the norm to purchase more than one produces

Instead of lamenting this, I suggest we embrace it. As we do so, jobs will be lost in service industries and gained in manufacturing. This is a transition that could occur fairly quickly if wages were permitted to become more flexible. Americans have lost a large portion of their competitive advantage. As such, they must be willing to accept lower wages. Over time, this competitive advantage may be regained and wages will rise with it.

Employment

The breathtaking rates of job losses we saw throughout 2008 largely abated in the spring of '09. But contrary to the spin, the employment market has not been improving. It simply stopped getting progressively worse. (ie. the second derivative was improving while the overall picture was still deteriorating).

Last Friday, we received the nonfarm payroll data for December. The headline establishment survey number showed an additional 85,000 job losses. But the more revealing number comes from the household survey. There, we learn that 843,000 stopped looking for work and fell out of the workforce. That makes for a yearly total of 3.5 Million that decided to stop looking for work. Some of these are discouraged; some are back in school; others might be boomers retiring. But a large majority of them will be back looking for work as soon as there is demand for their services and this will keep a lid on wages for many years to come. Add that to a gradually growing population and we are painted a very bleak picture.



Companies may have stopped firing workers en masse, but they are nowhere near ready to begin hiring.



This structurally high level of unemployment does not portend well for the "V-shaped recovery" thesis.

The silver lining in this may be that as hours worked and labour costs have been falling, output has fallen less. This means that productivity has been increasing. People are having to work harder in order to keep their jobs. Businesses have likely also tried to eliminate wasteful spending. This is always a good thing.



Investment

We become wealthier by learning how to produce more with fewer resources. We also "accumulate" capital goods that are able to produce more of what we want. As people die, others inherit these capital goods and knowledge at no cost to themselves. As a result, every subsequent generation is wealthier than the previous. The only way to reverse this trend is by destroying capital goods. This is typically achieved through war, but can also occur by not sustaining equipment and allowing it to fall into disrepair.

In much of the postwar period until the early 80's, nonresidential investment was a leading indicator for the economy. But then consumers began to leverage themselves and consumption growth was the main driver for the economy out of recessions. I believe that we will be experiencing a return to the previous order, as consumer credit remains constrained for the first time in decades and the trade balance comes back into line.



Unfortunately, investment has been taking the brunt of corporate retrenching. But as wages remain low, and productivity rises, large investment projects may become more feasible in coming years. This may not be the key to a recovering GDP, but it is a key to an improving economy. Investment has a positive multiplier effect on future rates of growth. Debt fueled consumption and government spending typically have a negative multiplier effect.

Conclusion

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.



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