Reasons for an impending US economic recession
page 2
Reasons for an impending US economic recession: The US trade deficit
In essence, the trade deficit alters the US economy’s structure in a negative way. The losing manufacturing area is the sector with the highest rate of capital formation, and therefore also the highest rate of productivity growth. For good reasons, it also pays the highest wages. Consider that US manufacturing lost 3 million jobs in the past few years. To be sure, the trade deficit is not its only reason, but unquestionably a major one.
Pondering the US economy’s unusually high addiction to credit and debt growth in relation to GDP growth, we are sure of another evil factor - Ponzi finance. Principally, every increase in spending brings about an equivalent increase in incomes. But this is not true in three cases of spending: first, spending on existing assets; second, spending on imports; and third, Ponzi finance.
Ponzi finance means that lenders simply capitalize unpaid interest rates. Ponzi finance creates credit, but it is bare of any demand and spending effects in the economy. In the conventional American view, balance sheets of private households are in their very best shape because increases in asset values have vastly outpaced the sharp increases in debts. So Americans see no problem.
With such great optimism about the US economy still prevailing, it is a safe assumption that lenders have been more than happy to capitalize unpaid interest rates as new loans, at least until recently. As widely reported, lending standards have been extremely lax for years. Nevertheless, there is bound to come a point where Ponzi lending stops.
The crucial difference is in the ghastly difference between runaway debt growth and nonexistent real disposable income growth as the income component from which debt service has to be paid. In 2000, consumer debt growth of 8.6% compared with real disposable income growth of 4.8%. During the first quarter of 2006, private household debt growth of 11.6%, annualized, compared with zero real disposable income growth.
These numbers suggest that, in the aggregate, all debt service occurs through Ponzi finance. Essentially, borrowing against existing assets is required to service debt. Another striking evidence of extensive Ponzi finance is the unusually large difference between rampant credit growth and much slower money growth. Capitalizing unpaid interest rates adds to outstanding credit and debt while adding nothing to bank deposits (money supply).
To get an idea of the actual extent of Ponzi finance, we make a simple calculation. Total outstanding debts in the United States amount to $41.8 trillion. Assuming an average interest rate of 5%, this implies an annual debt service of about $2 trillion. This compares with an increase in national income before taxes of $616 billion in 2005. Consumer incomes are even stagnant.
Under these conditions, the only question is the severity of the impending US recession. In this respect, we are a great believer in the axiom of Austrian theory that every crisis is broadly proportionate to the size of the excesses and imbalances that have accumulated during the prior boom. Our basic assumption is that the American consumer is bankrupt when house prices fall 20 - 30%.
The most important thing to realize is that the spending and debt excesses that have accumulated in the US economy and its financial system on the part of the consumer during the past 10 years are altogether of a size that vastly exceeds the potential for debt service from current income.
Reasons for an impending US economic recession: Debt trap
With stagnant real disposable income and double-digit debt growth, the American consumer is caught in a vicious debt trap. What, then, makes most people so optimistic of further economic growth? Apparently, there is a widespread view that households have sufficient equity cushions in their balance sheets to not only weather any storm ahead, but also to continue higher spending.
In our view, the most important thing to see is the fact that the US consumer has accumulated debts at a level vastly exceeding his abilities of debt service from current income. Probably many never had any intention of such kind of debt service. The general idea, certainly, has been to settle debt and debt service problems simply by selling later to the highly appreciated greater fool. That is what most economists take for granted.
What all these people overlook is, first of all, the vicious dynamics of Ponzi finance through compound interest on unproductive indebtedness. During 2000, total financial and nonfinancial credit and debt growth in the US amounted to $1,605.6 billion. In 2005, it had accelerated to $3,335.9 billion; and in the first quarter of 2006, it has run at an annual rate of $4,392.8 billion, and this now with zero income growth. Note that this debt explosion has happened with little change in GDP growth.
Given this precarious income situation on the one hand and the debt explosion on the other, it should be clear that at some point in the foreseeable future, there will be heavy selling of houses, with prices crashing for lack of buyers.
As to the level of asset prices in the United States, an additional comment is probably needed. Normally, the money for asset purchases comes from the savings out of current income. In the US economy, with savings in negative territory, all asset purchases essentially depend on available domestic credit and capital inflows. Buying assets on credit used to be the exception. In America today, it is the rule. For good reasons, the Fed is fearful to make money truly tight; it would crush the markets.
A study by the International Monetary Fund published in 2003 under the title "When Bubbles Burst" examined the differences in economic effects between bursting equity bubbles and bursting housing bubbles. It left no doubt that the latter are the far more dangerous specimen:
Reasons for an impending US economic recession: House price crash
Housing price crashes differ from equity price busts also in three other important dimensions. First, the price corrections during house price busts averaged 30%, reflecting the lower volatility of housing prices and the lower liquidity in housing markets. Second, housing price crashes lasted about four years, about 1 1/2 years longer than equity price busts. Third, the association between booms and busts was stronger for housing than for equity prices.
The situation today in the United States reminds us strongly of late December 2000. At its previous meeting in November, the Federal Open Market Committee directive had called future inflation the economy’s greatest risk. But then, all of a sudden, the bottom fell out of the economy. At its next meeting, on December 19, the FOMC changed the bias, declaring that the risk of economic weakness was outweighing the risk of inflation.
Two weeks later, Jan. 3, 2001, shocked by worsening economic news, the Fed dropped its funds rate, through a conference call, by 0.5% - twice the usual rate.
As we have stressed many times, the US economy today is incomparably more vulnerable than in 2000. All the growth-impairing imbalances in the economy - the trade deficit, the savings and incomes shortage and the debt levels - have dramatically worsened.
Very rapid interest rate cuts and prompt massive government deficit spending succeeded in containing the recession. The phoney "wealth effects" derived from the escalating housing bubble became the key source of demand creation in the United States. But the unpleasant longer-term result of the new policies was an unusually weak and lopsided economic recovery, particularly seeing drastic shortfalls in employment and income growth.
. Personally, I trust people honest enough to hang wild life trophies on the wall for all to see.
No lasting effects??
