US Economic Conundrum: American consumer spending in 2007 amounted to 72% of GDP but while there is broad agreement that American consumers are spending too much, when spending falters, there is a rush to try and restore it to previous levels.
As was the case with past warnings on scenarios similar to the current financial turmoil, the overspending by Americans as reflected in the large current account deficit, is seen by policymakers as a serious problem but one that can be left to the future, to either blow-up or be tackled. The latter is far from an easy path and many countries remain dependent on high American consumption.
Last week, Dr. Peter Morici of the University of Maryland, said that at about 5% of GDP, the huge current account deficit indicates Americans continue to consume much more than they produce, and borrow too much from the rest of the world
The current account deficit is nearly entirely caused by the huge deficit on trade in goods. In turn, the goods deficit is caused by a combination of an overvalued dollar against the Chinese yuan, a dysfunctional national energy policy that increases US dependence on foreign oil, and the competitive woes of the three domestic automakers. Together, the trade deficit with China and on petroleum and automotive products account for about deficit 90% of the deficit on trade in goods.
Morici says the current account deficit imposes a significant tax on GDP growth by moving workers from export and import-competing industries to other sectors of the economy. This reduces labor productivity, research and development (R&D) spending, and important investments in human capital. In 2007 the trade deficit is slicing off $300 to $500 billion off GDP, and longer term, it reduces potential annual GDP growth to 3% from 4%.
Last month we reported that economist Stephen S. Roach, Chairman of Morgan Stanley Asia said that no economy can live beyond its means in perpetuity. Yet like others that have tried to do so in the past, the US thought it was different. America’s current account deficit surged from 1.5% of GDP in 1995 to 6% in 2006. At its peak annualized deficit of $844 billion in the third quarter of 2006, the US required $3.4 billion of capital inflows from abroad each business day in order to fund a massive shortfall of domestic saving.
Roach says over the past two decades, America has had an audacious shift from income- to asset-based saving. The US consumer led the charge, with trend growth in real consumer demand hitting 3.5% per annum in real terms over the 14-year interval, 1994 to 2007 – the greatest buying binge over such a protracted period for any economy in modern history. Real disposable personal income growth averaged just 3.2% over the same period.
The binge was financed through equity release loans on homes and consumption rose to a record 72% of real GDP in 2007. It was "manna from heaven" for Developing Asia, but with the US consumer in trouble, Roach says Asia's export-led growth dynamic, may now be at risk.
Stephen Roach said that the global economy is facing a multi-year rebalancing.
For the US, this spells a sustained deceleration in personal consumption growth as households abandon newfound asset-dependent saving and consumption strategies in favour of the income-led fundamentals of the past.
"The US, in my view, will now have to come to grips with a much slower growth trajectory – with real GDP growth likely to slow from the 3.2% trend of the past 13 years to no higher than 2% over the next 2-3 years, or longer," Roach says.
"This should prove to be a very challenging outcome for the rest of the world – especially for those developing nations, which have derived so much of their economic sustenance from exporting goods to over-extended American consumers," he adds.
Morgan Stanley Report: Pitfalls in a Post-Bubble World
|US Bureau of Economic Analysis: Second Quarter 2008 - -The US current-account deficit--the combined balances on trade in goods and services, income, and net unilateral current transfers--decreased to $738.6 billion in 2007 from $811.5 billion in 2006.
Tuesday's Financial Times carried contrasting comments from economists, working at the the banks - Goldman Sachs and Merrill Lynch.
"One of the big lessons of the 1987 stock market crash, and again the 1998 Long-Term Capital Management debacle, is that by their fast reactions, policymakers can isolate "Wall Street" from "Main Street,""Jim O'Neill, chief economist of Goldman Sachs said.
This seems like a time warp from the credit bubble.
"Brainy" pundits can be indeed be confusing for the folk on Main Street and confused themselves.
Last week, the FT provided an illustration via a letter from Vineer Bhansali, a Managing Director at the multi-billion dollar bond fund PIMCO.
The Ph.D. in theoretical particle physics from Harvard University, opined that "restoration of confidence in the market is the only way out - and it requires two simple acts: firing Mr Paulson and Mr Bernanke; rehiring Alan Greenspan, the former Fed chairman, or someone with the confidence of the public."
"The US president and Congress have to step in and take these actions before the crisis of the academic Fed head creates a global depression," Bhansali concluded.
In fairness to PIMCO, its leading lights Bill Gross, Mohamed El-Erian and Paul McCulley, more than compensate for their colleague's idiocy.
Goldman's Jim O'Neill argues that the rise in consumption in the leading emerging market economies - Brazil, Russia, India and China (BRIC) countries - should be able to offset the slowdown in the US.
Russia is currently feeling the impact of the financial turmoil, while the movement from exports to domestic consumption in China, is still at an early stage.
The FT said on Tuesday that a weak social security network, meanwhile, forces Chinese to save too much and spend less than is good for the economy. “Everyone knows the current system gives too much preference to producers over consumers,” says a leading Chinese economist at a Beijing think-tank. “But now it is much clearer we need to put this theory into practice, which will not be easy.” <US slowdown spreads to rest of developed world and Asia>
Decoupling was a popular term a year ago but the reality that a slowing US economy impacts the rest of the world cannot be ignored.
"For global GDP to cope with lower US consumer spending, spending elsewhere has to rise. US spending, at 70% of US GDP, accounts for about 21% of global GDP. If it drops to 60% of the US, it will only contribute 18%," O'Neill said. "The BRICs shopper will help compensate for this, and they might also get some help from the German and Japanese shopper, although in a more limited way. That means that in the early part of this adjustment, global growth of 3.5% is perfectly feasible, even if we can't sustain 5%."
The last time US consumption was at 60% of GDP was in the early 1950's and no politician will dare interfere with the American dream of having your cake and eating it, anytime soon.
The dollar may do the trick eventually but that route has implications for interest rates and inflation.
Jim O'Neill said on Tuesday that the conditions for a significant recovery of equity markets have improved dramatically, not least helped by the sense of "crisis" which makes it easier for policymakers to act.
David Rosenberg, North American economist at Merrill Lynch, said that investors hoping that the US government's proposed $700bn Troubled Asset Relief Program to buy banks' toxic assets will signal a bottom for equities may be disappointed .
"Keep in mind," he said, "for all the bottom pickers out there, that after the Resolution Trust Corporation was established in 1989 it took a year for the stock market to bottom, two years for the economy to bottom and three years for the housing market to bottom.
"And recall that after the Financial Supervisory Agency in Japan was unveiled in 1997 the stock market there didn't bottom for another five years and it's an open question as whether the economy ever did manage to stage a sustainable recovery.
"In the Swedish case of the early 1990s, even with an effective government solution, the process of extinguishing the bad debts via government intervention was painful - the equity market incurred a 28-month bear market that saw Sweden's lead index decline 45% from peak to trough and the economy undergo a 20-month recession that saw domestic demand contract by 2.5%."
Rosenberg said that while the TARP may remove some fear from the market "we continue to believe that S&P 500 operating earnings will decline a further 7% next year, as the consumer recession that just began intensifies".
So who wants a long American consumer recession?