We are plunged deep into the biggest
credit-business cycle in world history. Many cycles have been worldwide, but
this one dwarfs all others, including the Great Depression.
An ocean of money and credit flooded every
corner of the globe. The culture of easy wealth worked its way into the
smallest economies from Norway to Chile, from Iceland to Mongolia. Economies
built on commodities exports, even energy exporters, have felt its impact.
The inevitable bust sent the world into
economic decline wiping out trillions of dollars of wealth. Built largely on
credit, the resulting debt is now being liquidated causing worldwide
deflation.
Business and credit cycles are always created
by central banks and this one is no different. While we can blame the greed of
Wall Street and London's City, capitalists are just players on a stage where
greed always exists. It takes something more than greed to create massive
cycles like these, and that something is the creation of money and credit out
of thin air, something only central banks and governments can do.
The economic world has changed. There are new
trends, megatrends if you will, now at work in our economy. They are "mega"
trends because they overarch and impact everything else in the economy and
will do so for quite a while.
There are other major trends at work as well,
but they have been operating as a part of the basic framework of our economy
for decades. These megatrends have emerged from the credit cycle because
people change their behaviors in response to a crisis, and it would be foolish
to assume that everything will just go back to the way things were before.
These aren't predictions of the future,
because circumstances change. No economist can accurately predict the future,
at least in the detail many economists claim they can do. There is just too
much data from the millions of decisions that our fellow citizens make every
day to know enough to predict with any accuracy.
How many economists predicted this crisis?
Very, very few. Think of these megatrends more as chalk marks on the playing
field that will guide human economic behavior for some years.
Megatrend No.1. The culture of consumption is
broken and won't return to former levels. This is the key to everything.
For the last 30 years our economy has been
based on personal consumption. From 1980 to 2007, personal consumption went
from 54.4% of GDP to 77.3%. We went on a spending spree financed by borrowing,
reduced savings, and asset inflation.
Most obvious was the rapid rise in home
prices. We came to think of our homes as an ATM, and kept pushing those
buttons. We felt rich: our homes appreciated, our 401(k)s appreciated, and,
who needs savings?
From the high of 2007 our net worth has
plunged 20% (nominal), from $62.591 trillion to $50.377 trillion as of Q1
2009. Down $12 trillion, or about equal to one year's GDP. That has dire
implications for consumer spending.
During the boom, debt as a percentage of
spendable income went from 68% in 1980 to 138% in 2007. We are now in the
process of paying it back. And, since our main assets, homes and stocks, have
declined, the bank wants its money back.
There is nothing like fear and an uncertain
future to prompt people to save. As the savings rate has increased, consumer
credit continues to decline, wages are decreasing, and unemployment is rising.
It will take consumers a long time to reduce their debt. If incomes don't grow
from current levels, it will take a savings rate of 5% to achieve a 5% annual
reduction in the household debt-to-income ratio, according to a McKinsey
Global Institute study.
At this rate it would take about 7 years for
this ratio to return to levels seen in 2000 (101% then, vs.138% today). If
incomes grow by 2%, then it would take a savings rate of 2.3% to achieve a 5%
reduction in the ratio. Every percentage point of savings reduces consumption
by about $100 billion per year.
This doesn't mean people won't spend; it
means they will spend less and save more. In an economy of which 70+% is based
on consumption, this represents massive change. It means that GDP will remain
subdued for a substantial period of time.
The one caveat? Inflation would tend to
result in quicker debt paydowns as old debt would be cheaper to pay off with
inflated dollars. Inflation would cause people to buy things as they dump
depreciating dollars for appreciating goods. But inflation has its own
problems.
Megatrend No. 2. Consumers will continue to
increase savings to prepare for retirement.
Boomers are facing retirement and they aren't
ready. In fact, about two-thirds of Boomers are unprepared according to
another McKinsey report. The definition of "prepared" is having enough income
to cover about 80% of pre-retirement spending. This is significant because
Boomers are 70 million strong, the largest population group in the U.S.
Since they entered the economy in the 1960s,
Boomers have driven GDP to new heights, have had the highest incomes, and have
accumulated the most assets. But the one thing they haven't done is still save
enough for retirement.
This has two important impacts. (1) They will
work longer to (2) accumulate savings in order to retire. While their
continued participation in the economy will be a positive, the fact that they
will restrict spending in order to save is a negative for an economy based on
consumption.
Also, as Boomers retire over the next five to
seven years, even assuming they continue to work a couple more years, a large
percentage, up to 40%, will still not have sufficient savings for retirement.
This has two negative impacts to the economy and consumer spending.
First, by reducing their participation in the
economy, GDP will go down. It's obvious that the more people in the workforce,
the greater economic activity there will be. Second, this large group won't be
spending as much during retirement.
There is one dirty little secret at the heart
of most Baby Boomers: their think their parents are going to leave them a lot
of money. Perhaps. But only a small percentage of Americans ever receive an
inheritance.
According to one study, only about 7 percent
of the population will ever inherit money - typically less than $25,000. Mom
and Dad are living longer and medical and nursing home costs are eating up
their assets. Only 1.6 percent of Boomers will inherit more than $100,000, and
they tend to already be successful in their own right.
Don't expect spending levels to stay at 70%
of GDP. I don't know what it will be, but if I were to guess, I would say it
would fall off to about 66% to 67%. We'll all have to adjust to this new
reality.
[Caveat: a consumption drop of just 3-4% may
be too conservative; long term American consumption may drop significantly
more. -JW]
Megatrend No. 3. Declining U.S. consumer
demand will continue to negatively impact the world economy.
The developing economies of the world live
off of demand from developed nations. Most of them have not created enough
wealth to generate sufficient internal demand for consumer goods to drive
their economies. While their domestic sectors are increasing, they are still
dependent on developed nations. If U.S. consumption continues to decline, the
countries that ship goods to us will suffer unless they can find new markets,
including domestic markets.
China's economy is based on exports and the
U.S. is its biggest trade partner. For the tenth month in a row, exports have
declined (23% YoY in August). China's recent economic gains are either
fictitious or a temporary result of government fiscal stimulus.
They are facing huge unemployment and
dislocation of their workforce. Some estimates put China's unemployment levels
at 24 million. China has engaged in massive Keynesian fiscal stimulus mostly
aimed at public infrastructure. These expenditures are about 14% of their GDP
($575 billion) but, with falling exports, it is unlikely that they can sustain
growth. It appears they are just creating another stock and property bubble.
We know that economic reports coming from
China are mostly numbers manufactured by Beijing. I would assume that
unemployment is higher. We take for granted that China will continue to grow
and become a leader in driving the global economy, and I believe that will be
so. But with 36% of their economy based on domestic consumption, they have a
long way to go before they are world economic leaders.
Megatrend No. 4. Deflation will continue for
some time.
Deflation occurs where there is a demand for
cash because of economic or political uncertainty, or where the demand for
money exceeds the existing money supply at any given moment. Both factors are
operating right now.
This is reflected in the economy by falling
prices, such as with real estate. Also the money supply is contracting despite
the efforts of the Fed. People are holding on to their cash. Keynes referred
to this as "hoarding" a pejorative term that suggests that people are too
stupid to handle their own affairs and that they should go out and spend to
help stimulate demand. As we've shown before, deflation is the necessary
healing process of any credit cycle boom and saving is a logical response to
uncertainty.
There is a lot of talk about inflation, but
you can't just look at the Consumer Price Index for guidance because it
doesn't include housing as a price component. Housing prices and commercial
real estate are the main asset classes now being deflated because of all the
debt incurred to buy real estate or finance consumption.
Wages and work hours are also decreasing, and
we have all seen the decline in the prices of many consumer goods. Consumer
credit continues to collapse as July marked six months of decline in a row,
down 10% this year. Banks continue to tighten credit as well.
Money supply, from M1 to MZM, is declining.
This is an international trend playing itself out in just about every country.
The Fed cannot stop declining asset prices.
[Caveat: others would argue that M0 has
increased 18% in the past 12 months; M1 has increased 8½ % in the past 12
months. -JW]
It's not over. Real estate prices will
continue to decline, although it is clear that we are starting to find a
bottom in residential real estate. The current devaluation of commercial real
estate is just starting. I believe many more banks will go under during this
phase of deflation. Credit card debt and student loans are another problem
area and debt reduction and bankruptcies will continue to put downward
pressure on prices.
Yes, at some point it is likely that credit
will expand again, and then we'll see inflation. But banks will continue to
hold on to their reserves until they see that they won't lose money making
loans.
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.
Every time the housing market goes through a
cycle, we are reminded by the housing industry that long term demographic
trends favor the construction of millions of new homes. It would be foolish to
argue the basic logic of this premise, but in the short term it never works
that way.
People do buy homes because of the
build-your-nest syndrome. But they also make economic decisions based on the
perceived risk versus reward of buying a home. Potential buyers have now
learned a valuable lesson. While they were told home prices would never
decline year-over-year, and that such declines hadn't occurred since the
1930s, they are painfully aware that it is happening now. This changes
people's perception of the economic benefits of home ownership.
From 1970 to 1995 home ownership rates were
about 64% to 65% of American families. Starting in 1995 they shot up reaching
a high of more than 69% in 2004 and 2005. We know the reasons for that (cheap
money and cheap credit), but I don't see that scenario repeating itself for
some years.
Also there is the fact that the number of
buyers who were "investing" in homes was as high as 24% of all sales late in
the cycle. This won't repeat itself either, barring a massive reinflation of
the housing market.
While home prices are declining, I think
buyers will continue to enter the market seeking bargains and eventually the
market will find a bottom, but I believe the "home-as-an-investment" concept
has been shaken off of its pillar and that this trend will reduce the rate of
homeownership to more historic levels. This will dampen the market for home
builders, reduce construction industry jobs, and squeeze profit margins for an
industry that was once about 3% of GDP.
Megatrend No. 6. Government stimulus and
recovery programs only delay recovery and deepen the pain for workers.
There has never been an example where
Keynesian government spending created real growth in an economy, anywhere.
We know that government spending through
fiscal stimulus has only been about $100 billion so far, not sufficient by
Keynesian standards to help a $12 trillion economy recover. So despite what
the Obama Administration says, they can't claim stimulus is working. For
example, Cash for Clunkers just "borrowed" against future sales and the effect
will wear off. The end result of stimulus is massively increased national
debt.
I have challenged Keynesians to point out an
example where Keynesian stimulus has worked and I have not had a response nor
have I seen any data that would support their premise.
Japan is the classic example where most of
the suggested Keynesian remedies were tried and failed miserably. The result
was economic stagnation from 1990 to 2003. And, they are doing the same things
again in this crisis. The result for Japan has been continuous, sluggish GDP
growth - an average of only 0.6% a year since 1991.
What these stimulus programs do is confiscate
money from some people and give it to others to spend on things the government
deems worthwhile.
You can see for yourself what these programs
are by going to Recovery.gov., the government's web site itemizing
expenditures under the American Recovery and Reinvestment Act. Much of it is
just a waste of money. And, once the money runs out the so-called economic
boost will end because the government doesn't create wealth, it just spends
it.
We're now two years into this crisis and
people are running out of unemployment benefits. Please compare the recession
of 1920 and 1921 to the recession-turned-into-a-depression of 1929-1948.
Harding and Coolidge basically did nothing
and the economy recovered from a worse crash than 1929. Yet the meddlesome
policies of Hoover and FDR turned an ordinary recession into a massive
depression. Politicians never learn.
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.
The Administration just announced that the
deficit over the next 10 years will be up another $2 trillion to $9.14
trillion which will push the true national debt to about $25 trillion by 2019.
This is double the current national debt and it will have negative economic
implications.
Even if the debt is increasingly financed by
U.S. savers, massive federal borrowing will put downward pressure on the
dollar threatening its status as an international reserve currency, which in
turn will drive up interest rates, and drive up the cost of capital for
private borrowers ("crowding out"). This means that it will be more difficult
to finance business which inhibits the creation of wealth and jobs.
The costs of Obamacare have been seriously
underestimated. Studies of national health care systems around the world
reveal that they have always exceeded cost estimates and our system, whatever
form it takes, will be no different.
Newly disclosed documents reveal that the
Johnson Administration knew that Medicare cost estimates given to the public
were a lie, but LBJ was afraid it wouldn't get past Congress if the true costs
were known. Medicare will probably not be reformed as a part of this bill, and
it is seriously underfunded. Medicare alone will need vast injections of
taxpayer dollars.
It is obvious where the money will come from
to pay the debt. I doubt the debt will be entirely funded by monetization
(printing dollars). It would worsen the problem and lead to high inflation and
Obama's advisers know this.
The money will come from new taxes on middle
income and upper income taxpayers. It can't be paid by upper income taxpayers
alone; there just aren't enough of them. Obama won't raise "middle class"
taxes or he will break an obvious campaign promise.
I believe that we will see a new, more
politically acceptable, tax, a national sales tax like the European VAT (value
added tax). At a recent Town Hall meeting with Treasury secretary Tim Geithner,
Geithner almost admitted that higher taxes were coming. I guarantee that they
will.
When a non-wealth creating entity like the
federal government takes that much capital out of the economy, it will slow
economic growth as interest rates rise and capital sources are diminished.
* * * * *
Where does all this lead?