Pouring the Red Ink Down the Sink

September 1, 2011

The Politics of Debt Repudiation

by MIKE WHITNEY

The US consumer’s decade-long spending spree has ended, but there’s still an ocean of red ink left to mop up. And with housing prices falling and unemployment tipping 9 per cent, it will take longer to clear the family balance sheet than many had anticipated.


Traditionally, the government has helped to ease the pain of deleveraging by providing fiscal stimulus to boost economic activity and lower the real cost of debt. But Capitol Hill is now in the grips of deficit hawks who frown on such Keynesian remedies, so households and consumers will have to fend for themselves and pay-down debts as best as they can or default when repayment is no longer possible . That’s bad news for the economy that depends on consumers for 71 percent of GDP. Without a healthy consumer, the economy will face years of sluggishness and stagnation.


U.S. household debt as a share of annual disposable income is currently 115 percent, down from the peak of 135 percent in 2008. But, while consumers are making headway in paring down their debts, there’s still a lot of work to do. Economists believe that the figure will eventually return to its historic range of 75 percent, which means slower growth for years to come unless someone else makes up the difference in spending.


But what sector is big enough to make up for the loss in consumer spending? Business? Government?


Business spending is still significantly below pre-crisis levels of investment. Naturally, businesses aren’t going hire more workers and produce more products if demand is weak. And, demand is bound to stay weak if there’s no rebound in consumption.  But how can the consumer rebound when he’s buried under a mountain of debt and making every effort to increase his savings? Surely, if wages were growing, then it would be easier to pay down debts while increasing spending at the same time. But wages aren’t growing, in fact, they are falling in inflation-adjusted terms. So personal consumption–which typically leads the way out of recession–will continue to disappoint. This is from an article by Stephen Roach titled “One Number Says it All”:

“There are two distinct phases to this period of unprecedented US consumer weakness. From the first quarter of 2008 through the second period of 2009, consumer demand fell for six consecutive quarters at a 2.2 per cent annual rate. Not surprisingly, the contraction was most acute during the depths of the Great Crisis, when consumption plunged at a 4.5 per cent rate in the third and fourth quarters of 2008.

As the US economy bottomed out in mid-2009, consumers entered a second phase – a very subdued recovery. Annualized real consumption growth over the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1 per cent. That is the most anemic consumer recovery on record – fully 1.5 percentage points slower than the 12-year pre-crisis trend of 3.6 per cent that prevailed between 1996 and 2007.

These figures are a good deal weaker than originally stated. As part of the annual reworking of the US National Income and Product Accounts that was released in July 2011, Commerce Department statisticians slashed their earlier estimates of consumer spending. The 14-quarter growth trend from early 2008 to mid-2011 was cut from 0.5 per cent to 0.2 per cent; the bulk of the downward revision was concentrated in the first six quarters of this period – for which the estimate of the annualized consumption decline was doubled, from 1.1 per cent to 2.2 per cent.

I have been tracking these so-called benchmark revisions for about 40 years. This is, by far, one of the most significant I have ever seen. We all knew it was tough for the American consumer – but this revision portrays the crisis-induced cutbacks and subsequent anemic recovery in a much dimmer light.” (“One Number Says it All”, Stephen S. Roach, Project Syndicate)

Roach’s timeline is key to understanding what’s going on. He says: “the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1 per cent.” The period that Roach calls a “very subdued recovery” coincides with the implementation of the $787 billion fiscal stimulus (ARRA).


Absent the Obama administration’s fiscal intervention, there would have been no recovery. This is worth considering in view of the fact that households continue to pay-down debts and will do so for the forseeable future. If the government doesn’t provide additional stimulus, then the economy will slip back into negative territory. And that’s precisely what’s happening now. Here’s an excerpt from an article by John P. Hussman, Ph.D, Hussman Funds who connects the dots drawing from recent data:

“It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that is always and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5 per cent…, year-over-year GDP growth below 2 per cent, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1 per cent, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but the evidence we observe at present has 100 per cent sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100 per cent specificity (the only time we observe the full set of these conditions is during or just prior to U.S. recessions). This doesn’t mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that “this time is different.” (“A Reprieve from Misguided Recklessness”, John P. Hussman, Ph.D, Hussman Funds)

Policy should be based on more than hope. It should be grounded in a firm grasp of macroeconomics and a commitment to the common good.


Keep in mind, that during the peak bubble years of 2000 to 2007 households nearly doubled their “outstanding debt to $13.8 trillion” and “personal consumption grew by 44 per cent from $6.9 trillion to $9.9 trillion”. Also, from 2003 to the third quarter 2008 US households extracted $2.3 trillion of equity from their homes in the form of home equity loans and cash-out refinancings” (figures from “Will US Consumer Debt Cripple the Recovery”, McKinsey Global Institute)


$2.3 trillion! Think about that. That’s nearly $500 billion that was being pumped into the economy every year, which is more than Obama’s $787 stimulus distributed over a two-year period. That’s why unemployment stayed low while housing prices ballooned, because loose lending standards and easy money inflated the biggest credit bubble of all time. But now the trend has reversed itself and debt-deflation dynamics are in play forcing consumers to cut spending, increase saving, and pay down their debts. Only the federal government has the ability and the wherewithal to support the flagging economy while the process continues. The government must boost its spending, increase the deficits, and assist in the deleveraging process. This is from an article by economist Laura Tyson titled “Recovering from a Balance-Sheet Recession”:

“In other recoveries during the last 50 years, public-sector employment increased. This time it is falling: during the last year the private sector added 1.8 million jobs while the public sector cut 550,000.

What should policy makers do to combat the large and lingering job losses that result from a financial crisis and balance-sheet recession? Mr. Koo, whose book on Japan’s experience should be required reading for members of Congress, showed that when the private sector is curtailing spending, fiscal stimulus to increase growth and reduce unemployment is the most effective way to reduce the private-sector debt overhang choking private spending.

When the Japanese government tried fiscal consolidation to slow the growth of government debt in response to International Monetary Fund advice in 1997, the results were economic contraction and an increase in the government deficit. In contrast, when the Japanese government increased government spending, the pace of recovery strengthened and the deficit as a share of gross domestic product declined….” (“Recovering from a Balance-Sheet Recession”, Laura D’Andrea Tyson, New York Times)

Did you catch that? When the Japanese government tried to decrease the deficits by slashing spending, they increased the deficits. This is the lesson that every country in the EU –which has applied the ECB-IMF austerity measures—has learned. Cutting spending when the economy is weak is bad policy and bad economics. Struggling economies must "growth" their way out off of recession by spending liberally and putting people back to work, thus adding to government revenues. Here’s Tyson again explaining why this is so:

“The market understands that the most important driver of the fiscal deficit in the short to medium run is weak tax revenues, reflecting slow growth and high unemployment, and that additional fiscal measures to put people back to work are the most effective way to reduce the deficit.

“Every one percentage point of growth adds about $2.5 trillion in government revenue. An extra percentage point of growth over the next five years would do more to reduce the deficit during that period than any of the spending cuts currently under discussion. And faster growth would make it easier for the private sector to reduce its debt burden….Under these conditions, slow growth leads to a higher debt ratio, not vice versa…” (“Recovering from a Balance-Sheet Recession”, Laura D’Andrea Tyson, New York Times)

So, how do we speed up the deleveraging process so the economy can get back on track?


First, the government must be committed to long-term “sustained” fiscal stimulus until the share of household debt to disposable income returns to normal. Second, there should be a restructuring of household and personal debts “including”,– as economist Carmen Reinhart says– “debt forgiveness for low-income Americans”….


“Until we deal head-on with the fact that some of those debts are not ever going to be repaid, we will continue to have this shadow over growth”, Reinhart told Bloomberg News last weekend.


Debt repudiation, principle write-downs on underwater mortgages and amnesty on delinquent student loans should all be added to the mix of stimulants to future growth.


Finally–along with federally-funded government jobs programs (a revised WPA, etc)–Congress needs to address the chronic supply-demand imbalance that has emerged from Labor’s dwindling share in corporate profits. The imbalance has now reached historic levels which has widened gross inequality and threatens to keep the economy in a semi-permanent state of Depression. Here’s a quick summary from Barry Ritholtz’s “The Big Picture”:

“Labor share averaged 64.3 percent from 1947 to 2000. Labor share has declined over the past decade, falling to its lowest point in the third quarter of 2010, 57.8 percent. The change in labor share from one period to the next has become a major factor contributing to the compensation–productivity gap in the nonfarm business sector….

While Labor Share has recently plummeted to all-time lows since record keeping began, Median Household Income has stagnated for the past 12 years. In the last recession (2001), incomes had only begun to decline…. One decade later, Labor Share has collapsed, incomes have gone nowhere, and credit availability… has all but vanished except for the most creditworthy…” (“The Heart of the Matter”, The Big Picture)

Not only is labor getting a smaller and smaller piece of the pie, but, also, financial engineering–spurred-on by low interest rates and deregulation–has given rise to consecutive credit bubbles which have transferred a larger share of pension and retirement fund-wealth to Wall Street speculators. So, working people are not just getting screwed on their labor, the government and central bank are actually helping to facilitate the pilfering of their savings.


At the same time, corporate profits have continued to skyrocket. As the Wall Street Journal’s Kelly Evans notes, “Since the recession ended in mid-2009, U.S. corporate profits have jumped by about 43 per cent to a record $1.45 trillion as of the first quarter, after taxes, inventory and accounting adjustments, according to the Commerce Department.” (“More Liquidity Only Douses Growth Sparks”, Wall Street Journal)


So, despite sky-high unemployment, household deleveraging, historic inequality and slow growth; profits keep rising. Is there any doubt about whose interests are being served.


The only way out of the mess that workers find themselves in, is through politics. And–on that score–FDR said it best:

“We cannot allow our economic life to be controlled by that small group of men whose chief outlook upon the social welfare is tinctured by the fact that they can make huge profits from the lending of money and the marketing of securities–an outlook which deserves the adjectives ‘selfish’ and ‘opportunist.’” –Franklin Delano Roosevelt, “FDR Explains the Crisis: Why it feels like 1932″, Pam Martens, CounterPunch.

Time to rebalance

America’s economy is set to shift away from consumption and debt and towards exports and saving. It will be its biggest transformation in decades, says Greg Ip (interviewed here

Mar 31st 2010 | From The Economist

STEVE HILTON remembers months of despair after the collapse of Lehman Brothers in 2008. Customers rushed to the sales offices of Meritage Homes, the property firm Mr Hilton runs, not to buy houses but to cancel contracts they had already signed. “I thought for a moment the world was coming to an end,” he recalls.

In the following months Mr Hilton stepped up efforts to save his company. He gave up options to buy thousands of lots that the firm had snapped up across Arizona, Florida, Nevada and California during the boom, taking massive losses. He eventually laid off three-quarters of its 2,300 employees. He also had its houses completely redesigned to cut construction cost almost in half: simpler roofs, standardised window sizes, fewer options. Gone were the 12-foot ceilings, sweeping staircases and granite countertops everyone wanted when money was free. Meritage is now catering to the only customers able to get credit: first-time buyers with federally guaranteed loans. It is clawing its way back to health as a leaner, humbler company.

The same could be said for America. Virtually every industry has shed jobs in the past two years, but those that cater mostly to consumers have suffered most. Employment in residential construction and carmaking is down by almost a third, in retailing and banking by 8%. As the economy recovers, some of those jobs will come back, but many of them will not, because this was no ordinary recession. The bubbly asset prices, ever easier credit and cheap oil that fuelled America’s age of consumerism are not about to return.

Instead, America’s economy will undergo one of its biggest transformations in decades. This macroeconomic shift from debt and consumption to saving and exports will bring microeconomic changes too: different lifestyles, and different jobs in different places. This special report will describe that transformation, and explain why it will be tricky.

The crisis and then the recession put an abrupt end to the old economic model. Despite a small rebound recently, house prices have fallen by 29% and share prices by a similar amount since their peak. Households’ wealth has shrunk by $12 trillion, or 18%, since 2007. As a share of disposable income it is back to its level in 1995. And if consumers feel less rich, they are less inclined to spend. Banks are also less willing to lend: they have tightened loan standards, with a push from regulators who now wish they had taken a dimmer view of exotic mortgages and lax lending during the boom.

Consumer debt rose from an average of less than 80% of disposable income 20 years ago to 129% in 2007. If other crises of the past half-century are any guide, America’s consumers will spend the next six or seven years reducing their debt to more manageable levels, reckons the McKinsey Global Institute. This is already changing the composition of economic activity. Consumer spending and housing rose from 70% of GDP in 1991 to 76% in 2005 (see chart 1). By last year it had fallen back to 73%, still high by international standards.

The effect on the economy of deflated assets, tighter credit and costlier energy are already apparent. Fewer people are buying homes, and the ones they buy tend to be smaller and less opulent. In 2008 the median size of a new home shrank for the first time in 13 years. The number of credit cards in circulation has declined by almost a fifth. American Express is pulling back from credit cards and is now telling customers how to use their charge cards (which are paid off in full every month) to control their spending.

Normally, deep recessions are followed by strong recoveries as pent-up demand reasserts itself. In the recent recession GDP shrank by 3.8%, the worst drop since the second world war. In the recovery the economy might therefore be expected to grow by 6-8% and unemployment to fall steadily, as happened after two earlier recessions of comparable depth, in 1973-75 and 1981-82.

No bounce-back

But this particular recession was triggered by a financial crisis that damaged the financial system’s ability to channel savings to productive investment and left consumers and businesses struggling with surplus buildings, equipment and debt accumulated in the boom. Recovery after that kind of crisis is often slow and weak, and indeed some nine months into the upturn GDP has probably grown at an annual rate of less than 4%. Unemployment is well up throughout the country (see map), though it declined slightly in February.

So if America is to avoid the stagnation that afflicted Japan after its bubbles burst, where is the demand going to come from? In the short term the federal government has stepped up its borrowing—to 10% of GDP this year—to counteract the drop in private consumption and investment. Over the next few years this stimulus will be withdrawn. Barack Obama wants the deficit to come down to around 3% of GDP by the middle of this decade, though it is not clear how that will be achieved. Indeed, if the rest of the economy remains moribund, the government may be reluctant to withdraw the stimulus for fear of pushing the economy back into recession.

Tighter credit and lower consumer borrowing are not the only drivers of economic restructuring. A less noticed but significant push comes from higher energy prices. A strengthening dollar and ample supply kept oil cheap for most of the 1990s, feeding America’s addiction to imports. That began to change a few years before the crisis as the dollar fell and emerging markets’ growing appetite put pressure on global production capacity.

A fourfold increase in oil prices since the 1990s has rearranged both consumer and producer incentives. Sport-utility vehicles are losing popularity, policies to boost conservation and renewable energy have become bolder, and producers have found a lot more oil below America’s soil and coastal seabed. Imports of the stuff have dropped by 10% since 2006 and are likely to come down further. When natural-gas prices followed the rise in oil earlier this decade, exploration companies used new methods to get at gas trapped in shale formations from Texas to Pennsylvania. Abundant domestic shale gas should radically reduce America’s gas imports.

America’s economic geography will change too. Cheap petrol and ample credit encouraged millions of Americans to flock to southern states and to distant suburbs (“exurbs”) in search of big houses with lots of land. Now the housing bust has tied them to homes they cannot sell. Population growth in the suburbs has slowed. For the present the rise of knowledge-intensive global industries favours centres rich in infrastructure and specialised skills. Some are traditional urban cores such as New York and some are suburban edge cities that offer jobs along with affordable houses and short commutes.

A burst of productivity could lift incomes and profits. That would enable consumers to repay some of their debt yet continue to spend. The change in the mix of growth should help: productivity in construction remains low, whereas in exports the most productive companies often do best. But the hobbled financial system will make it hard for cash-hungry start-ups to get financing, so innovation will suffer.

The outlook for business investment depends on whether it is for equipment or buildings. Spending on equipment is expected to be fairly strong, having largely avoided excess in the boom period, and indeed in the fourth quarter of 2009 it raced ahead at an annual rate of 19%. In February John Chambers, the boss of Cisco Systems, a maker of networking gear, called it “one of the most robust, positive turnarounds I’ve seen in my career”. Demand for new buildings is far lower: empty shops and offices attest to ample unused capacity. And business investment typically accounts for only 10-12% of GDP, so it will never be a full substitute for consumer spending.

The road to salvation

As consumers rebuild their savings, American firms must increasingly look abroad for sales. They have a lot of ground to make up. Competition from low-wage countries, mostly China, has increasingly taken over the markets of domestic industries such as furniture, clothing or consumer electronics. Yet shifts in the pattern of global growth and the dollar are laying the groundwork for a boom in exports. “There’s a world view that the United States is the consumer of the world and emerging markets are the producer,” says Bruce Kasman, chief economist at JPMorgan Chase. “That has changed.” He reckons that America will account for just 27% of global consumption this year against emerging markets’ 34%, roughly the reverse of their shares eight years ago.

The cheaper dollar will resuscitate some industries in commoditised markets, but the main beneficiaries of the export boom will be companies that are already formidable exporters. These companies reflect America’s strengths in high-end services and highly skilled manufacturing such as medical devices, pharmaceuticals, software and engineering, as well as creative services like film, architecture and advertising. Thanks to cheap digital technology, South Korea and India now knock out the sort of low-budget films that compete with standard American fare. But only Hollywood combines the creativity, expertise and market savvy to make something like “Avatar” which has earned $2.6 billion so far, some 70% of which came from abroad. That adds up to several jumbo jets.

Exports are a classic route to recovery after a crisis. Sweden and Finland in the early 1990s and Thailand, Malaysia and South Korea in the late 1990s bounced back from recession by moving from trade deficit to surplus or expanding their surplus. But given its size and the sickly state of most other rich countries’ economies, America will find it much harder. It has been exporting more to emerging markets than to developed ones for several years, but if other countries, particularly China, do not sufficiently boost domestic demand, “the unwinding of the global imbalances could reverse quite quickly in 2010,” says an IMF staff paper.

America’s current-account deficit, the broadest measure of its trade and payments with the rest of the world, shrank from 6% of GDP in 2006 to 3% last year (see chart 2). Could it come down to zero? It nearly did in 1991 after five years of booming exports. This time the deficit started out a lot larger and the rest of the world is weaker. Still, even stabilisation around 3% would be a blessed relief because it would slow the growth in America’s indebtedness to foreigners.

America’s imbalances were years in the making and will not be undone overnight. But the elements of a rebalanced economy are already visible a 40-minute drive to the south of Mr Hilton’s offices in Scottsdale, Arizona. Around the same time that Mr Hilton was watching sales of his homes dry up, Brian Krzanich, head of global manufacturing at Intel, was finalising plans to spend $3 billion retooling his company’s massive semiconductor factories in nearby Chandler. Mr Krzanich knew perfectly well there was a recession going on. Intel’s sales were down and 3% of the staff at the factories had been laid off. But he also knew that once global demand rebounded, Intel would have to be ready to produce a new generation of cheaper, smaller and more efficient chips. 

“Unless you think your business is going to shrink for an extended period, like seven years, it always pays to make that investment,” he says. 

In the last quarter of 2009 Intel, helped by resurgent demand for technology, enjoyed record profit margins, and Mr Krzanich was approving overtime.Mr Hilton, for his part, runs his company on the assumption that the days of easy money and exuberant consumers are gone for ever. In his office he has a yellowed copy of theWall Street Journal from September 18th 2008, the week when Lehman failed and American International Group was bailed out. “Worst crisis since the 30s with no end in sight”, reads one headline. “I wish I’d had that article in 2005,” says Mr Hilton. He keeps it around as an antidote any time he is “feeling all happy and slappy”.