By Mike Whitney
July 03, 2009 “Information Clearing House”
There’s a big difference between inventory-driven recessions and credit-driven recessions. An inventory recession is caused by a mismatch between supply and demand. It’s the result of overcapacity and under-utilization which can only work itself out over time as inventories are pared back and demand builds. Credit-driven recessions are a different story altogether. They typically last twice as long as and can precipitate financial crises. The current recession is a severe credit bust of Depression-era magnitude. The financial system has effectively melted down. The wholesale credit system (securitization) is frozen, the banking system is dysfunctional and insolvent, and consumer spending has tanked. The Fed’s multi-trillion dollar lending facilities and monetary stimulus have kept the financial system from grinding to a halt, but the underlying problems still persist. Fed chairman Ben Bernanke has chosen to avoid the hard decisions and keep the price of toxic assets artificially high with the help of a $12.8 trillion liquidity backstop. That’s why stocks have rallied for the last 4 months while conditions in the real economy have steadily deteriorated. Bernanke is using all the tools at his disposal to keep the market from clearing and prevent the mountain of debt that has built up over decades from being purged from the system. Unfortunately, as Ludwig von Mises said, “There is no means of avoiding the final collapse of a boom brought on by credit expansion.”
The surging stock market has made it harder to see that the economy is resetting at a lower rate of economic activity. Deflation is setting in across all sectors. Housing prices are leading the retreat, falling 18.1 percent year-over-year according to the new Case-Schiller report. Vanishing home equity is forcing households to slash spending which is weakening demand and triggering more layoffs. It’s a vicious circle which ends in slower growth.
Also, the banking system is still broken. The $700 billion TARP program was not used to purchase toxic assets, but to buy equity stakes in the banks and to bailout insurance giant AIG. Bernanke knows that a hobbled banking system will be a constant drain on public resources, but he refuses to nationalize the banks or restructure their debt. Instead, he’s expanded the Fed’s balance sheet by $1.2 trillion and ignited a rally in the stock market. Bernanke’s bear market rally has lifted the financials from the doldrums and generated the capital the banks need to survive the downgrading of their bad assets. Former Fed-chief Alan Greenspan (unintentionally) clarified this point in an editorial in the Financial Times:
“The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies…. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.
Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. (Alan Greenspan, “Inflation, The real threat to a sustained recovery”, Financial Times)
Clearly, Bernanke was thinking along the same lines as Greenspan when he decided to push traders back into the market with his generous liquidity programs and quantitative easing (QE). He probably realized that political support for more bailouts had waned and that “large amounts of new equity” ( Greenspan’s words) would be needed to keep the banks from defaulting. Whatever his motives may have been, Bernanke’s stimulus has turbo-charged equities while the real economy continues to sputter.
Jordan Irving, who helps manage more than $110 billion at Delaware Investments in Philadelphia told Bloomberg News, “This has been a government-induced rally. We need to see some real positives coming from internal demand, as opposed to government-related demand, and it’s just not there.”
Still, the Fed’s intervention in the markets hasn’t removed the threat posed by toxic assets; a problem which only gets worse over time. That’s why The Bank of International Settlements (BIS) issued a report last week warning of the “perils” of not tackling the issue head-on. Here’s an excerpt from the report:
“… Despite months of co-ordinated action around the globe to stabilize the banking system, hidden perils still lurk in the world’s financial institutions according to the Basel-based Bank of International Settlements.
“Overall, governments may not have acted quickly enough to remove problem assets from the balance sheets of key banks,” the BIS says in its annual report. “At the same time, government guarantees and asset insurance have exposed taxpayers to potentially large losses.”
… As one of the few bodies consistently sounding the alarm about the build-up of risky financial assets and under-capitalized banks in the run-up to the credit crisis, the BIS’s assessment will carry weight with governments. It says: “The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.” (UK Guardian, Recovery threatened by toxic assets still hidden in key banks )
The toxic assets problem is further compounded by an estimated $2 trillion of additional losses from defaulting residential mortgages, commercial real-estate loans, credit card loans, and auto loans. It’s is the double-whammy; a fetid portfolio of non-performing loans and garbage mortgage-backed derivatives. At the same time, personal consumption has fallen sharply and the signs of economic contraction are visible everywhere, from the bulging homeless shelters, to the long-lines at the unemployment offices, to the empty state coffers, to the half-filled shopping carts at the grocery store. Unemployment is rising at 600,000 per month, consumer confidence is at record lows, retail sales have fallen sharply, and housing continues its historic plunge. The data is clear; there are no green shoots or silver linings. Billionaire Warren Buffett summed it up like this in an interview with CNBC this week:
“I get figures on 70-odd businesses, a lot of them daily. Everything that I see about the economy is that we’ve had no bounce. The financial system was really where the crisis was last September and October, and that’s been surmounted and that’s enormously important. But in terms of the economy coming back, it takes a while…. I said the economy would be in a shambles this year and probably well beyond. I’m afraid that’s true.”
The best snapshot of the economy appeared in the Fed’s Beige Book, which was released two weeks ago, but was barely covered in the financial media. The report gives a candid assessment of an economy that is in deep distress. Here’s an excerpt:
“Reports from the twelve Federal Reserve District Banks indicate that economic conditions remained weak or deteriorated further during the period from mid-April through May…Manufacturing activity declined or remained at a low level across most Districts…. Demand for nonfinancial services contracted across Districts reporting on this segment. Retail spending remained soft as consumers focused on purchasing less expensive necessities and shied away from buying luxury goods. New car purchases remained depressed, with several Districts indicating that tight credit conditions were hampering auto sales. Travel and tourism activity also declined….Vacancy rates for commercial properties were rising in many parts of the country… Credit conditions remained stringent or tightened further. Energy activity continued to weaken across most Districts, and demand for natural resources remained depressed…. Labor market conditions continued to be weak across the country, with wages generally remaining flat or falling….Districts reporting on nonfinancial services indicated that for the most part activity continued to decline…. Activity continued to weaken or remain soft for providers of professional services such as accounting, architecture, business consulting, and legal services….Consumer spending remained soft as households focused on purchasing less expensive necessities. …Travel and tourism activity declined, and vacationers are tending to spend less….
Commercial real estate markets continued to weaken across all Districts. …With few exceptions, the District Banks reported that prices at all stages of production were generally flat or falling…Reports from a number of Districts indicated that pricing at retail remains very soft…” (Fed’s Beige Book)
It’s all bad.
The financial meltdown has left homeowners with the worst debt-to-income ratio in history. Working people have been forced to cut discretionary spending and begin to save. The household savings rate zoomed to 6.9 percent in May, a 15-year high. The rate in April 2008 was zero.”
The downside of the rising savings rate, is that it will deepen and prolong the recession. The negligible increase in retail spending can be attributed to fiscal stimulus. Without the government checkbook, the economy will continue to struggle.
There’s been a sudden shift from debt-fueled consumption to thriftiness. The trauma of losing one’s job, health care or home; or simply living one paycheck away from disaster will probably shape attitudes for years to come. Personal savings will continue to swell as households build a bigger nest egg to weather the slump and make up for lost equity, droopy retirement accounts, and the possibility of losing their job. This fundamental change in consumer behavior points to less economic activity, more inventory reduction, additional layoffs, and smaller corporate profits. When consumers save, the economy contracts. Rob Parenteau, editor of the Richebacher Letter, sums it up like this:
“We have never seen households retire debt like this, now in three of the past four quarters, over more than a half century of results reported in the Flow of Funds accounts….(“Q1 2009 Flow of Funds results show the housing sector ran a net saving position of $341b in the past quarter, while paying down $155b in household debt)
….the widespread perception is that the old global growth model, dependent in no small part on the willingness of US consumers to deepen their deficit spending, can and will be revived. We would merely suggest with the level of household net worth to disposable income back to a level last seen in 1995 (before household deficit spending began), and with households extinguishing debt for the first time in over half a century, this assumption deserves to be questioned. Humpty Dumpty may not be able to be put together again.” (“What is Different this Time?”, Rob Parenteau, editor of the Richebacher Letter, and a research assistant with the Levy Institute of Economics, naked capitalism.com)
Consumer spending is 70% of GDP, but consumers have suddenly stepped on the brakes. This is a real game-changer. Even if the credit markets are restored and the banks show a greater willingness to lend; there will be no return to the pre-crisis consumption-levels of the past. Those days are over. Households will have to devote more income to paying down debt and less on shopping, travel or nights-on-the-town. That means the Obama team will have to make up the slack in demand by providing more fiscal stimulus, jobs programs, state aid, and other forms of public relief. It’s the only way to keep the economy from sliding deeper into depression. And, don’t expect past consumption trends to predict the future. It’s a whole new ballgame. The Federal Reserve Bank of San Francisco explains the roots of the problem in their “Economic Letter: US Household Deleveraging and Future Consumption Growth”. Here’s an extended excerpt:
“U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007. That dramatic rise in debt was accompanied by a steady decline in the personal saving rate. The combination of higher debt and lower saving enabled personal consumption expenditures to grow faster than disposable income, providing a significant boost to U.S. economic growth over the period.
In the long-run, however, consumption cannot grow faster than income because there is an upper limit to how much debt households can service, based on their incomes. For many U.S. households, current debt levels appear too high, as evidenced by the sharp rise in delinquencies and foreclosures in recent years. To achieve a sustainable level of debt relative to income, households may need to undergo a prolonged period of deleveraging, whereby debt is reduced and saving is increased.
Beginning in 2000, however, the pace of debt accumulation accelerated dramatically…Rising debt levels were accompanied by rising wealth. An influx of new and often speculative homebuyers with access to easy credit helped bid up prices to unprecedented levels relative to fundamentals, as measured by rents or disposable income. Equity extracted from rapidly appreciating home values provided hundreds of billions of dollars per year in spendable cash for households that was used to pay for a variety of goods and services….Rapid debt growth allowed consumption to grow faster than income.
Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go?
Going forward, it seems probable that many U.S. households will reduce their debt. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates. (“U.S. Household Deleveraging and Future Consumption Growth, by Reuven Glick and Kevin J. Lansing, FRBSF Economic Letter”)
Household wealth has slipped $14 trillion since the crisis began. This includes sizable losses in investments, real estate and retirement funds. Home equity has dropped to 41% (a new low) and joblessness is on the rise. When credit was easy; borrowing increased, assets prices rose and the economy grew. Now the process has gone into reverse; credit has dried up, collateral values have plunged, GDP is negative, and consumers are buried under a mountain of debt. Personal bankruptcies, defaults and foreclosures are all up. Deflation is everywhere. It will take years, perhaps a decade or more, to rebuild household balance sheets and restore the flagging economy. The consumer is running on empty and the chances of a robust recovery are nil.