Revisited: Where is the Money Coming From to Fund Spending

When I make a mistake I will admit it.

In my analysis of consumer spending I asserted that the sources of increases in spending were (1) a draw-down of savings and (2) the redirection of defaulted mortgage payments to spending. I was half-right which another way of saying I was half-wrong.

I missed one the basic laws of economics, Bastiat’s “Broken Window Fallacy.” You know, the kid breaks the cobbler’s window, the cobbler pays for a new window and everyone thinks that the cobbler’s spending helped the economy because the glazier had work. The fallacy is that the cobbler was going to buy new clothes from the tailor and now can’t afford it. So the cobbler still has a window, is out the cost of the window repair and the new clothes. It’s a net loss to the economy.

The lesson is that you always need to look at the unseen as well as the seen. I missed that point entirely when I claimed that people spending their mortgage payments on consumer goods. Someone loses here and that is the lender. I forgot to ask what the lender was going to do with the money. Thanks to Caroline Baum, the very excellent writer for Bloomberg to point out the obvious. (See, “Honey, I Lost the House. Now It’s Time to Party.”)

Mea culpa and apologies. Unfortunately many, many people made the same mistake (Mark Zandi, David Rosenberg among others).

So, back to the numbers.

Analysis of Sales Report

March retail sales were up 1.6% over February, and +7.6% from a year earlier, not adjusted for inflation. The annual nominal rise was the largest since July 2005. Eleven of 13 major categories showed increases in sales.

Here are the major components of the Census Department report representing 77.4% of total sales:

First, it is important to note that sales have trended upward since reaching bottom in December, 2008. Here is a wonderful chart from Vix and More putting the decline and recovery of retail sales in perspective as of (as of February 15, 2010; these numbers are not adjusted for inflation):

Here is a chart from Seeking Alpha (Wildebeest) that shows retail sales adjusted for inflation (solid line is 12 month moving average):

This trend is occurring despite high unemployment, declining wages, and other negative factors mentioned in my original article. Nominal discretionary spending  increased for the first MoM period in 28 consecutive months.

Without autos, building and garden materials, and apparel, all discretionary spending, retail sales would have been relatively flat especially if one considers the ±0.5% margin of error. Adjusted for inflation real discretionary retail sales were a -1.18% YoY.

What Drove Discretionary Sales?

What drove those discretionary items which contributed the most to the 1.6% increase and where did the money come from?

Auto sales were driven by deals. Discounts, interest-free financing, the impact of Toyota’s deals to keep market share, and other incentives were the main factors. People need new cars and if you consider that 83% of the population have jobs, that Cash for Clunkers (ending August, 2009) ate into future sales, that people have been putting off buying a new car because of economic uncertainty, the MoM and YoY gains  represented pent-up demand.

Securitized nonrevolving consumer credit, which finances auto sales, has actually increased in the last few months which shows that buyers are relying on auto company and bank financing to purchase the hot deals. This was the only element of consumer credit that rose. This would not impact savings.

I don’t expect it to represent a long-term trend.

Building and garden materials is a response to a pick-up in home sales. While low prices are the primary driver of this market, the market has been artificially stimulated by the Cash for Condos program, a tax credit that ends on April 30. Existing home sales surged 6.4% in March MoM. I expect home sales to decline after April. Other factors, such as increased foreclosures, tightening financing standards (FHA), and rising interest rates will act as a natural brake on sales. I expect sales to remain flat. This would cause home improvement related sales to decline.

Apparel sales did well. The reasons given are that better weather and an early Easter holiday boosted sales. I think that is accurate.

There may be some immediate effect on spending as borrowers spend their mortgage money, but the obvious impact is that it will have a negative effect on the economy in the medium to long-term. It doesn’t take much time for people to spend their “free” money, but it takes longer for the shortages to impact the lenders, almost all large financial institutions or RMBSs.

Status of Economic Recovery

It is apparent that the economy is starting to rebound. There are several reasons for it. One is that, despite the fact that the long-term impact is negative, there is a lot of fiscal stimulus working its way through the economy. I believe this will have a short-term effect only and will wear off when the money is spent.

I believe there are too many headwinds in the way of a recovery that will impact the economy some time in H2. I have written about this many times and referred to some of these factors in the original version of this article.

There is another factor which I have also written about. That is that some of this recovery is real. The U.S. economy has a remarkable ability to correct its mistakes after a bust, reallocate capital to profitable ventures, and grow again. I cannot discount this fact even though I believe the data doesn’t quite support that conclusion.

I don’t think that any Austrian theory economist could honestly come to any conclusion on that because it is too difficult to know if “real” capital is sufficient to support new growth. And the reason is that the government is doing so many things to thwart and delay a recovery by supporting companies and industries that need to fail.

Primary among those government policies that delay a recovery is allowing banks to stay alive when they should fail. This is the cause of the credit freeze and credit as money supply continues to decline. In the real estate crash of the late 1980s, more than 2,000 banks, and 1,589 S&Ls, were closed,  the Resolution Trust Corporation sold assets wholesale. Bad assets were disposed of, balance sheets were cleared, banks were closed, and credit flowed again. The economy went into recession in 1990 and started recovering after 8 months. This is not happening this time.