It has been my thesis for some time that we are seeing a secular change in consumption patterns in the United States. This will have grave implications for a world economy used to seeing the American consumer as an economic growth engine and consumer of first choice. Retail sales in the United States have fallen 10% since peaking in November 2007. Much of this decline represents a permanent fall in consumption by overly indebted American consumers.
Having finally had a chance to dissect the retail sales data from last week, I wanted to show you a few graphs which indicate how much consumption has fallen in the present downturn and what the implication is for the future global economy. But, first, I want to start with a broader discussion as to why the fall in US consumption is a longer-term change and not a cyclical one.
The Balance Sheet Recession
Numerous economies seem on the way to recovery: Germany and France, Singapore, and Hong Kong, to name a few, have all posted positive economic growth. China looks likely to hit its 2009 growth target of 8%. But, the U.S., generally assumed to be a leader in recovery, is looking like a laggard. Mind you, there are other laggards like Spain and Ireland too. Why are these countries lagging? The Balance Sheet Recession.
Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.
When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many, forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three Ds come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.
Secular inflation will be non-existent
Therefore, the problem is a lack of demand for loans not a lack of supply. The Federal Reserve can print all the money it wants. But if there is little demand for more indebtedness, it is not going to have the desired effect of permanently reflating the economy – although it can create bubbles.
The corollary of this is that inflation will be non-existent on a secular basis. For the increase in liquidity to feed into consumer price inflation, people have to actually buy more stuff. And that’s not what happens in a balance sheet recession because people are concentrated on reducing debt and increasing savings.
Moreover, there is a huge glut of excess capacity globally now that we have had a major fall in consumption. Producers are waiting for demand to catch up with supply – not exactly the sort of situation that makes for inflation. I should point out that capacity is not fixed – it grows obsolete if unused. So much of the investment in manufacturing capacity in China and property in America is going to have to be liquidated eventually.
But, the economy doesn’t move in a straight line. It courses through cycles. Just as we could be entering a cyclical recovery in the middle of a depression, it is altogether possible that the Federal Reserve can produce high cyclical levels of inflation despite the secular trend toward disinflation. A lot of this is likely to come through commodity prices or destruction of the currency.
For example, while the change in consumer prices has gone negative in the United States since the downturn began…
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when one strips out food and energy, it has declined much less than even during the last deflation scare of 2001-2003, which caused Alan Greenspan to panic and reduce interest rates to 1%.
The discrepancy above is due wholly to changes in commodity prices. So, if commodity prices re-assert themselves going forward, we could see a major uptick in inflation. Moreover, a fall in the value of the dollar could precipitate inflation as well. And finally, there is asset prices. It is clear the Federal Reserve and the Obama Administration are targeting asset prices in order to reflate the economy. All of that stimulus can and will create cyclical inflationary forces which could be large. Nevertheless, the underlying level of demand is slack and that means secular inflation levels will remain subdued. See my post “Central banks will face a Scylla and Charybdis flation challenge for years” for more on this concept.
This means the consumer will be under pressure
High debt and low inflation mean lower consumption growth. It’s hard to spend more when you have a mountain of debt staring you in the face and its not getting reduced in real terms through inflation.
Look at the charts to the right. They come from a story in Barron’s this weekend called They Shopped ‘Til They Dropped. They depict a tsunami of debt in the U.S. economy that has been building for four decades. Even debt service levels have been inching inexorably higher since the 1980s. Clearly, the U.S. consumer is tapped out. And they are cutting consumption and reducing debt as a result.
So, for America, it is not business but consumers which are going to suffer a balance sheet recession. In looking for evidence on Koo’s thesis, we need to look at consumption and retail sales.
Michael Shedlock recently reported on the horrible back to school sales numbers. And Patty Edwards, a well-known Seattle-based retail analyst, was recently on Bloomberg radio with sobering anecdotal detail regarding the retail sector. She sees no sign of an impending uptick in US retail sales and is very worried about the Christmas selling season. The audio of her conversation with Tom Keene is below (not available in the RSS feed). It is very much in line with the balance sheet recession argument.
Shedlock’s post and Edwards’ view are very much in line with the retail sales numbers we saw late last week. A lot of people had been looking for good retail sales numbers because they see recovery at hand. But, the numbers disappointed, falling 0.1% from the previous month.
This puts retail sales 8.3% below year-ago levels and a full 10% below peak levels in November 2007. This is much more severe a decline than we witnessed in the shallow recession of 2001. When retail sales numbers hardly declined. In fact, on a nominal basis, they fell on a year-on-year basis only during September 2001 because of September 11th.
If one uses data both the present data series (1992 – present) and the previous data series (1967-2001), this downturn looks much more inline with the steep downturns of the 1970s and 1980s.
The key difference between then and now is the debt levels I showed you from the Barron’s article. Let’s not forget low savings as well.
One can only conclude that the asset-based economy of the last quarter century is over. It was based not just on a dubious productivity miracle but also on mountains of debt and over-consumption. The new normal is debt reduction and savings.
What does this mean for the economy? Here are a few macro themes:
- Retailers are in a world of hurt, not just cyclically, but on a secular basis. Listen to the Patty Edwards interview. America has double the amount of retail space per capita that it did a generation ago. This is the definition of over-capacity. When a glut of supply meets a deficit of demand, you have the makings of a very bad outcome for the stocks in that sector. This is the same conclusion that the Barron’s article comes to. The uptick in retail shares like JC Penney (NYSE:JCP), Ann Taylor (NYSE:ANN), and Macy’s (NYSE:M) is all due to beating low earnings estimates. As a result, Abercrombie (NYSE:ANF) has almost doubled. Nordstrom (NYSE:JWN) is up 141% and Ann Taylor is up a massive 350%. Investors like George Soros are selling retail (Wal-Mart (NYSE:WMT), Walgreen (WAG) and Lowe’s (NYSE:LOW)).
- Commercial Real Estate will feel the pain too. The Patty Edwards interview not only shows huge excess capacity in retail, but it shows that retailers are trying to re-negotiate contracts down. They have Commercial REITS over a barrel because they can just threaten to close down outlets if they don’t get the contract price concessions they seek. Back in January, I mentioned the fact that bankrupt anchor tenants like Circuit City destroy the economics of malls for other tenants and create a domino effect. So, if anchor retailers do not get the price concessions they want, they will shut down stores, creating a huge loss in income for all the other stores. Obviously, this will drive down the price of commercial real estate as there will be a huge glut of supply.
- Export-oriented economies need to foster internal demand growth. Here I am talking about Germany, Japan, and China amongst the major economies. The US consumer is out of gas and these countries are too dependent on exporting to US consumers. It is not clear who can replace her. Certainly, the Chinese government and companies are doing their level best to foster domestic demand in China, even conspicuous consumption. But, the Chinese are unlikely to replace Americans as the new global growth engine anytime soon.
- The new normal is lower US and global growth. This all suggests that we are likely to see lower growth in the US and globally as a result – at least until the American consumer gets out of a hole or someone else picks up the slack. That will likely mean we will see low-growth, short business cycles punctuated by fits of recession, all complicated by the three D’s (debt deflation, deflation, and depression).
- One should fear a 1937-style relapse. If you recall, the Great Depression saw a major economic uptick in the years after 1932. No one would call this a boom (see the section called “recovery does not mean recovery” in my post “Economic recovery and the perverse math of GDP reporting.”) This was only a statistical recovery in the midst of a greater downturn. Eventually, stimulus was withdrawn and the economy tanked again. Richard Koo argues that Japan did not go into a 1929-style depression because it maintained much more stimulus than the US did in the Great Depression. If this stimulus is removed before the deleveraging and balance sheet repair is complete, you get a major relapse. So, beware of deficit hawks telling us that fiscal stimulus must end to eliminate deficits. If anything, the government’s long-term deficit outlook should be eliminated via reining in skyrocketing health care costs.
- Banks will be in a permanent state of crisis. If we learn anything from Japan, it’s that time does not heal all wounds. The Japanese tried to recapitalise their banking system by propping up zombie institutions. That didn’t work. It didn’t work in Japan in the 1990s and it didn’t work with Savings & Loans in the US in the 1980s. Why should we expect it is going to work now? But, team Obama has decided this is the way forward. If and when an economic relapse occurs, the fragility of the banking system will be made manifest. Much of the so-called toxic assets is still on the balance sheet of American financial institutions. The same is true in countries like Germany, Spain and Ireland, to name a few. When another downturn hits, those assets will go bad and writedowns will drag down the weakest institutions. This is the lesson of Japan.
- Liquidate zombies while providing counter-cyclical stimulus. The banking example gives a hint to the correct policy response. It is not a return to the bubble days of the asset-based economy. It is not creating deficits as far as the eye can see while perpetuating overcapacity. What policymakers need to do is allow bankrupt organizations to fail and reduce excess capacity, all the while providing enough stimulus to prevent worst-case outcomes.
When it comes to US consumers, weak spending growth will last for years. Ultimately, debt levels in the US economy must return to a sustainable level. This can happen over time, which would mean a decade-long low-growth, muddle-through economy – not a terrible outcome either for the economy or for asset prices.
Or it could happen overnight through default, bankruptcy, and liquidation – a Great Depression II scenario. The policy response in the US and elsewhere will make the difference. Right now, we are headed for a statistical recovery at best. If policymakers think we are off to the races and try to normalize policy, they will be making a heinous mistake.