Today’s article is a follow up to The Aftermath of the Great Recession, Part I. I am covering the material I will present at ASPO-USA’s Denver conference on October 11-13, 2009. I am making this presentation available before the conference in part because there is more material here than I will be able to cover during my introductory talk on the economics panel.
The outlook for consumption growth in the over-leveraged United States is bleak. Economists Menzie Chinn and Jeffrey Frieden discussed the origins of the financial crisis, the debt situation in the U.S. and the global outlook in Reflections on the Causes and Consequences of the Debt Crisis of 2008. This text broadly describes the origin of the crisis.
The United States has borrowed and spent itself into a foreign debt crisis. Between 2001 and 2007, Americans borrowed trillions of dollars from abroad. The federal government borrowed to finance its budget deficit; private individuals and companies borrowed so they could consume and invest beyond their means. While some spending went for physical commodities, including imports, much of the spending was for local goods and services, especially financial services and real estate. The result was a broad-based, but ultimately unsustainable, economic expansion that drove up the relative price of goods not involved in foreign trade—things like haircuts, taxi rides, and, most important, housing. The key “nontradable” good was housing; that boom eventually became a bubble…
This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash. In broad outlines, the cycle describes the developing-country debt crisis of the early 1980s, the Mexican crisis of 1994, the East Asian crisis of 1997-1998, the Russian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000-2001—not to speak of the German crisis of the early 1930s or the American crisis of the early 1890s.
[My note: This is an economist’s view of the causes of the meltdown. The oil price shock of 2007-2008 contributed significantly to the downfall, as James Hamilton has documented. Menzie Chinn is Hamilton’s writing partner at their blog Econbrowser.]
Of course, a prolonged debt crisis in the United States has much larger global effects than a crisis in Mexico or Argentina. You will recall from last week that—
- Massive debt-fueled consumption in the United States drove the global economic boom of recent years, and thus the oil demand shock of 2002-2007.
In thinking about where we stand right now, this summary from Chinn and Frieden is helpful.
We are now witnessing the unwinding of this process of debt accumulation. Households and firms are busily trying to reduce their debt loads, in the face of dimmer prospects for income and profits. For households, savings rates are rising, but at the cost of stagnant consumption. For firms, the reduction of debt load is consistent with a reduced rate of investment in plant and equipment. In some sense, this process of retrenchment is necessary. For many years, the United States consumed more than it produced. We borrowed and for a while thought that the old rules had been suspended. But now it turns out that we do have to pay back what we have borrowed. The attendant higher saving rate and lower investment rate will lead to a substantial improvement in the current account balance, or in other words, the paying off of our debt.
More broadly, though, this also means that the United States cannot rely upon the driver of growth that has sustained it over the past three decades—namely consumption. But the consequences extend beyond the nation’s border. The world can no longer rely upon the American consumer. Who will take up this role remains to the next big question.
The world can no longer depend on the American consumer. What country will fill the consumption gap? Many have pinned their hopes on China, to which I now turn.
A Resurgence in China?
Figure 11 — China’s balance of trade, 2007-August, 2009.
- China’s exports were down 23.4% year-over-year in August, 2009. This is a disaster for an export-oriented economy.
- The decoupling theory, wherein China could escape relatively unscathed from an economic crash in the United States and the Eurozone, is dead. (See this bullish article from the WSJ which attempts to resuscitate this view based on recent bubbly economic growth in China.)
- I highly recommend this video about China’s export economy, which features a tour of some of their empty factories.
- China has a huge over-capacity problem. They built a manufacturing base to service (via exports) large & growing consumption in the United States (and elsewhere) that no longer exists as it did prior to the crash. (See remarks by financial adviser Hugh Hendry in my A Resurgence in China? He compares China to an investor in a Bernie Madoff-like Ponzi Scheme in America.)
Figure 12 — U.S. Trade Balance (in billion dollars per month) from 1994 through July, 2009
- The other side of the Chimerica coin. The U.S. trade imbalance reached it’s highest point in the first half of 2008 after widening steadily since 2002.
- Between 2001 and 2007, the American current account (trade) deficit averaged between $500 billion and $1 trillion every year, resulting in a deficit equal to an unprecedented 6% of GDP in 2006. In other words, the U.S. effectively “borrowed” this much money every year. Much of that money went toward purchases of residential real estate causing the Housing Bubble.
- The exports-imports gap has narrowed considerably as the U.S. imports much less stuff generally and particularly from China. There has been a small uptick in both exports & imports in the last few months.
- Exports – Imports is a (negative) term in calculating GDP (see Part I). So, a narrower gap between the two boosts GDP even if exports are down year-over-year.
Figure 13 — China’s GDP growth, 2006-2009:Q2
- 2nd quarter growth reflects the massive Chinese stimulus (4 trillion RMB, $586 billion, ~14% of GDP, Ren Min Bi, or the People’s Money). This explains growing oil demand since March, 2009. August came in at 7.71 million barrels-per-day, down from the peak in July.
- Is this growth for real? The problem arises with how China figures GDP growth. See China: Bogus Boom? “China’s 8% output growth target will be met because [their] economic statistics are based on recorded production activity (spending), rather than being a measure of expenditure [final demand] growth.” The mere dispersal of stimulus funds [e.g. to provincial governments] are counted as GDP growth, whether that money is used or not.
- Most of this Chinese investment goes to fixed assets (e.g. infrastructure), not manufacturing where there is so much overcapacity. My favorite example involves tearing down and then rebuilding perfectly good structures. “A 2.9-kilometer elevated highway in Hunan [was] demolished when it was meant to last for 36 more years. A “bridge of strength,” nicknamed as such because it was unscathed by last year’s devastating earthquake, [was] dynamited in Sichuan.” The Chinese will rebuild these structures and thus boost GDP.
- All this explains why the Financial Times’ Martin Wolf has suggested that “China should forget having a GDP target, instead of having an 8% growth GDP target, it should have a real domestic demand target. It should think of its policy in terms of generating real domestic demand, [and] GDP will follow.”
- It’s hard to imagine that this craziness is sustainable, and thus will drive China’s future oil demand up and up.
Figure 14 — China is blowing bubbles in their economy as stimulus money floods into assets (equities, housing) or bogus fixed investment instead of into over-built manufacturing capacity
- China’s growing bubbles are just where you would think they would be—the stock market (e.g. the Shanghai Composite) and urban residential housing. From Bank of China’s Zhu Sees ‘Bubbles’ in Asset Values (Bloomberg, September 10, 2009)—
Bank of China, Ltd. led the nation’s $1.1 trillion lending spree in the first half of 2009, said ample liquidity has caused “bubbles” in stocks, commodities and real estate…
“There’s no way for the real economy to absorb so much liquidity,” said Liu Yuhui, a Beijing-based economist at Chinese Academy of Social Science. ”Policymakers in China and around the world are well aware of the harm that could do, but they are unwilling to sacrifice short-term growth and wean the economy from addiction to the stimulus policies.”
The Shanghai Stock Exchange Composite Index has gained 61 percent this year, compared with a 20 percent increase in the MSCI World Index of 1,659 companies. House prices in China’s 70 biggest cities rose at the fastest pace in 11 months on record lending and climbing confidence, according to a National Bureau of Statistics report today.
- China’s bubbles are a direct result of the Chinese massive stimulus program and Bank of China’s lending, but Premier Wen Jiabao is keeping the pedal to the metal, just as Tim Geithner and “Helicopter” Ben Bernanke are in the United States (see below).
- Similar bubbles are inflating all over Asia. Singapore recently moved to curb speculation in its real estate market, putting the lie to Dr. Alan Greenspan’s (and Bernanke’s) peculiar view that speculative inflation of assets can not be detected or managed in advance.
- The Chinese leadership presses on with the stimulus because they are running scared politically. China must have very high growth rates to provide work for the many millions of young people entering the job market each year. But in trying to forestall an economic crisis that threatens their power, they are risking an even worse collapse of their economy.
- China expert Andy Xie makes an apt comparison between China in 2009 and Japan in 1989.
China can learn a lot from Japan’s experience as well. Its bubble formed when companies began focusing on financial investments rather than core business. In the 1980s, Japan’s corporate sector tapped the corporate bond market and raised massive amounts of capital for asset purchases. Recently, Chinese enterprises borrowed money and pumped it into asset markets. They essentially provided leverage for asset markets. When leverage was rising, asset inflation occurred, letting companies book profits that were many times greater than operating profits from core businesses. That gave them greater incentive to pursue asset appreciation rather than operating profitability. The corporate sector became a shadow banking system for financing asset speculation.
Thus, China’s corporate sector is now behaving in a way similar to what was seen in Japan two decades ago.
Here’s my China summary—
- China will not provide the consumption engine the global economy requires for sustained growth—their economy (domestic demand) is too small.
- China’s corporate sector is focused on profiting from inflated assets instead of their core businesses. Little growth is possible for core businesses because exports have been shrinking rapidly and internal demand is not growing significantly.
- The Chinese, traditionally a nation of savers, needs to build up their domestic demand. This requires steady “organic” year-over-year growth over the next decade or longer. Otherwise, the economy overheats and you get mis-allocation of resources (capital) and bubbles (like now).
Let’s return to stimulus, deficits and indebtedness in the United States. After that, I’ll sum up.
Figure 15 — Total U.S. debt by sector (households, non-finance business, finance, government)
- All debt is approximately 350% of nominal GDP (~$14 trillion).
- Government debt has remained at a relatively consistent percentage of GDP for the past 50 years, but the debt of companies, consumers, and financial businesses has soared.
- The government is now making up for past lack of excess (see Figure 16 below).
Figure 16 — Federal revenues and non-interest spending from the Congressional Budget Office
- This is fiscal debt (e.g. the current $787 billion stimulus shown as a bump in the graph) as opposed the Fed’s monetary stimulus.
- Broadly speaking, the U.S. is replacing private debt with public debt.
- See my The Incredible Shrinking Boomer Economy for details.
- The CBO’s “Alternative Fiscal Scenario” is the one considered most realistic given past political decisions and current realities.
- Health care spending (Medicare & Medicaid) increases the debt significantly as the Boomers retire.
- The Obama administration recently raised its 10-year budget deficit projection to $9 trillion (from $7.1 trillion).
- This graph does not reflect interest payments that must be made on the debt.
- If the U.S. does not have steady GDP growth, future revenues will fall below trend unless taxes are raised.
Figure 17 — The Federal Reserves assets (uses of funds) since December, 2007.
- A short history of printing money. Assets were $2.119 trillion as of September 2, 2009.
- The sizable declines in short-term lending to financials and non-bank credit markets have largely been offset by increases in holdings of Treasury securities, agency mortgage-backed securities (MBS), and agency debt (Fannie Mae, Freddie Mac). (Only fixed-rate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for the program.) Treasury purchases monetize some of the U.S. debt.
- Quantitative easing (QE) refers to a series of steps to flood financial markets with liquidity, including the purchase of mortgage backed securities, to help keep long term (mortgage) rates low. The Federal Open Market Committee has held the fed-funds rate at a lowest-ever range of 0% to 0.25% since December 2008. (Technical note: Open market operations—purchases and sales of U.S. Treasury and federal agency securities—are the Federal Reserve’s principal tool for implementing monetary policy… The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.)
- The value of the Fed’s agency MBS purchases depends on a shaky real estate market (see Figure 9, part I). See the Wall Street Journal’s Uncle Sam Bets the House on Mortgages.
- The Fed will not disclose its dealings with banks—they are being sued by Bloomberg—or allow an audit of its transactions.
- Some expect QE—monetary and rate stimulus—to continue right through 2010 and perhaps into 2011! This is a recipe for disaster (see the summary below).
Summary And Outlook—Factors Affecting Recovery
There is an Alphabet Soup describing the shape of the recovery for the short to medium term (next few quarters out to 2013) or long term (out to 2020): V (rapid, sustained recovery), U (longer, slower recovery), W (double-dip recession) or L (long-term depression).
- The shape of the recovery determines future oil demand, and thus the timing of The Next Oil Shock.
- The Fed’s exit strategy presents a fundamental dilemma: (1) if interest rates are tightened too fast, the risk is that any economic “expansion” will be nipped in the bud; (2) if rates stay too low for too long, the risk is for new bubbles as described next.
- The longer that QE and fiscal stimulus go on unabated in the United States, China and elsewhere, the more certain it becomes that new destructive bubbles will develop in world markets. This is already occurring in China. Excess liquidity looking for places to invest drives unwarranted asset price inflation. The S&P 500 is looking very bubbly already as money flows into equities.
- There have been no reforms of Big Finance, so highly-leveraged risk-taking proceeds apace, aided by QE (free money). There is no check on risky bets because losses have been “socialized” (put on the shoulders of current or future tax payers). See Peter Boone and Simon Johnson’s The Next Financial Crisis.
- Only government spending is driving GDP growth in the United States and China. None of the other factors—consumption expenditures outside health care, fixed investment, or the trade balance—will significantly contribute to GDP for some time to come.
- If things go very badly in the next 10 years—for example, the Japanese and Chinese stop buying our debt or (worse) start dumping dollars—the U.S. could be effectively bankrupt by 2020. Interest rates and prices would go through the roof. History tells us the traditional solution has been to launch a Foreign War.
- Consumption will remain depressed in the United States for a long time as households repair balance sheets. The loss of wealth (in housing, stocks) and the threat of unemployment further curtail spending. Retiring Boomers make the situation much worse in the long term.
- Unemployment will remain high in the United States for a long time as weak banks repair balance sheets (limiting credit) and businesses limit investment until such time as renewed consumption warrants expansion. The world has a large excess capacity overhang, which discourages new investment which leads to job growth.
- The overbuilt real estate markets (residential, commercial) in the United States will remain weak for many years. Prices will remain depressed in the medium to long term and excess inventory must be worked off in the short to medium term.
- China will not lead the world out of recovery as described above.
- If China and the United States do not lead a global recovery, then who will?
Thus, in considering the shape of the global economic recovery (as measured by GDP) in the short to medium term, it seems highly unlikely that we will get a V-shaped recovery. I agree with William White, who is quoted in the Financial Times’ Leading Economist Fears Double-Dip Recession—
The world has not tackled the problems at the heart of the economic downturn and is likely to slip back into recession, says one of the few mainstream economists who predicted the crisis.
Speaking at the Sibos conference in Hong Kong yesterday, William White, the former chief economist at the Bank for International Settlements, also warned that government actions to help the economy in the short run might be sowing the seeds for future crises.
“Are we going into a W [-shaped recession]? Almost certainly. Are we going into an L? I would not be in the slightest bit surprised,” he said, referring to the risks of a so-called -double-dip recession or a protracted stagnation such as Japan suffered in the 1990s.
“The only thing that would really surprise me is a rapid and sustainable recovery from the position we’re in.“
Nouriel Roubini has noted the heightened risks for a W-shaped double-dip recession. The majority of economists still see a U-shaped recovery. In either case, we can not expect a strong rebound in global economic growth, and thus oil demand, in 2010 and perhaps future years as well. In The Next Oil Shock, I predicted that the next oil price shock would occur around 2012 as shown in Figure 18. This forecast was consistent with a U-shaped global recovery.
Figure 18 — Another oil price shock in 2012 +/- 1 year. Whenever it occurs, the next oil shock will have a severe impact on a fragile world economy.
That’s my story and I’m sticking to it. But it could be wrong for any number of reasons. We could have a prolonged L-shaped depression. Or the Fed’s exit strategy could be botched and we will end up with another severe recession. And then there are the inflation/deflation issues—Eric Janszen will talk about those at the conference. A global economy that depended so heavily on Chimerica is unsound. There is great danger all around us. No one knows what the next shoe to drop will be. Or when that will happen.
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