State of the Economy Part I

This is the first report of a series of 3 reports on the state of the economy as we enter 2010. Part II will appear Wednesday, and Part III will be posted on Thursday.

I have been poring over current economic data, year-end reports from various sources, and current or proposed legislation. It leads me to conclude that my views of the economy’s future have not substantially changed.

I think it still comes down to the real estate market, deleveraging, organic business cycle recovery, changed consumption patterns, and taxation and regulation. Layer on top of that the Fed’s options.

It still is not pretty.

The basic question you have to ask is: what will drive the economy forward?

Right now the answer is capital. And here I am not talking about money the government spends to stimulate the economy.

I am referring to private capital supplied by merchant banks from new savings or accumulated capital. I am talking about investment capital from savings directed into various conduits such as hedge and venture capital funds, various private lending sources such as factors and leasing companies, investment banks, pension funds, insurance companies, the securities market.

If consumer spending is the bedrock of our economy, then consumer spending without the juice that makes capitalism flow equals slow or no growth.

As we all know, the juice has dried up. And the reason for it is that there is still a substantial amount of debt on the books of financial institutions and individuals that needs to be liquidated or paid off. Deleveraging. Until that happens the economy will stagnate. At this point there is not much more the government can do; their attempts to “cure” the problem are making things worse.

There is another overriding factor to consider: This is the biggest financial crisis the world has ever experienced. The bubble reached unprecedented highs in a vast portion of the planet and debt levels have never been as great on a worldwide basis. It is a mistake to think this is just another recession, as most economists do. While the impacts of such financial crises have been similar throughout history, one must fully appreciate the scope of this one.

Fundamental Considerations

Last year I wrote “Economic Megatrends That Will Drive Our Future.” These “megatrends” as I called them represent fundamental changes to the economy:

Megatrend No. 1. The culture of consumption is broken and won’t return to former levels.

Megatrend No. 2. Consumers will continue to increase savings to prepare for retirement.

Megatrend No. 3. Declining U.S. consumer demand will continue to negatively impact the world economy.

Megatrend No. 4. Deflation will continue for some time.

Megatrend No. 5. Home ownership rates will decline to more historical levels of, say, around 66%, down from the high of 69% during the boom, which will keep a lid on home prices.

Megatrend No. 6. Government stimulus and recovery programs only delay recovery and deepen the pain for workers.

Megatrend No. 7. Massive federal deficits will double the national debt, result in higher taxes, and will act as a permanent drag on the economy.

These conditions will continue to hold back GDP growth for some time. Many economists predict that things will go back to “normal” though perhaps slightly less robust as before. They are wrong.

What we can conclude from these megatrends:

1. Consumer spending will be subdued especially among the biggest spenders: the Boomers.
2. Households will reduce debt and increase savings.
3. Housing demand will decline.
4. As the government becomes a larger factor in the economy as a percentage of GDP, economic growth will decline.
5. Higher taxes will be needed to pay for increasing deficits which will also subdue economic growth.

These are facts, not guesses.

The Consumer

Personal Consumer Expenditures (PCE) have accounted for about 70% of the economy. PCE does include Medicare expenditures for individuals so it’s a bit skewed.

What you can see from this chart is a rebound in consumer spending as a result of fiscal stimulus, mainly from Cash for Clunkers (See the durable goods section of GDP), and from holiday discount sales. Consumer spending increased in November for the sixth time in seven months.  Retailers increased sales 3.3% in January. The biggest rise was in apparel retailers.

Then there is the reduction of household debt:

Note in the above household debt chart, how debt exploded after 2000. Rising home prices was the asset base for the debt. The boom was credit financed: consumers borrowed rather than saved.

And now the personal savings rate is growing rather dramatically:

As you can see, consumers are reducing debt and increasing savings (4.8% per latest numbers). You will note savings decreased a bit at year end. That is where the cash for the blip in consumption came from. You will also note that saving is resuming it’s climb (4.8%).

Consumer credit has tanked. In November, the latest numbers, consumer credit fell by $17.5 billion. “The series of 10 straight declines was the longest since record-keeping began in 1943. … Consumer credit outstanding decreased at a seasonally adjusted annual rate of 8.5% to $2.465 trillion …”

Banks are reluctant to lend, credit card debt has declined, and consumers, worried about the economy, debt, and retirement, are saving.

Unemployment

Unemployment hasn’t improved much, and as the recent employment numbers reveal, while the rate of unemployment is slowing down, the actual numbers of unemployment remain high, at 9.7%, although down from 10%.

Presently U-6 unemployment is still very high: 16.5%, but down from 17.3% in the prior month. U-6 is: “Total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers.” This includes about 2.5 million workers who aren’t even looking for jobs anymore.

Wages and income are at all-time lows:

Wage and benefit costs, both before and after adjusting for inflation, grew more slowly in 2009 than in any year since the U.S. government began tracking data in 1982, as double-digit unemployment weakened workers’ ability to command higher pay.

Adjusted for inflation, wages and benefits fell 1.3%, after rising 2.8% in 2008, the first year of the recession. The inflation-adjusted cost of wages and benefits at the end of 2009 stood just 1.1% higher than at the end of the previous recession in 2001, the Labor Department said.

In his January 29 report, David Rosenberg noted, “In Q4 aggregate private hours worked contracted at a 0.5% rate. Never happened in last 50 years with GDP growth at 5.7%.”  He questions the robustness of GDP. The other side of this is that productivity output per worker increased on a ”seasonally adjusted annual rate of 6.2% in the October-to-December period.”  This says that employers have streamlined production and operations, are lean and mean, and are reluctant to hire until they are sure demand has really improved.

Without rising incomes, you can’t have increased savings and reduction of debt AND increased consumption. Savings defers consumption. Incomes are flat, as shown above.

Fiscal Stimulus

Christina Romer told us when unemployment was 8% we needed fiscal stimulus to stop unemployment from going to 9%. At 10% we are told we need even more stimulus. The Administration is trying to claim that fiscal stimulus has been a big success. But they have only spent $58 billion of $200 billion in federal contracts, grants, and loans awarded out of a total of $275 billion alloted for such expenditures. Not, as Paul Krugman keeps reminding us, sufficient (according to Keynesian theory) to revive a $14 trillion economy.

It is true that fiscal stimulus has an impact on GDP, so it is unfair to say such stimulus cannot create any economic activity. The problem is that it doesn’t create wealth which is the foundation for true “organic” economic growth. Stimulus is really just a transfer payment: taking money from one person and giving it to someone else to spend on something the government wants. There is absolutely no evidence that Keynesian stimulus is working now or  has ever worked where employed. And, no one ever asks the person whose money funded such stimulus what he/she was going to do with the money–how much private economic activity was lost as a result?

Regardless, despite calls for more stimulus, there appears to be little political will for it. It is no coincidence that we are hearing talk of “fiscal responsibility” and “worrisome debt” from the Obama Administration. Obama realizes that runaway spending and rising deficits jeopardize his ambition for expensive social programs such as “free” health care and “free” college education. They have given up on stimulus and are focusing on a jobs bill that they hope will reduce unemployment before the next election. Thank you, voters of Massachusetts.

See Part II tomorrow