Painful Adjustment Ahead For The U.S. Economy

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by: Shareholders Unite

There are simple, but difficult to recreate reasons why the US has been so successful economically. There are advantages on the supply and on the demand side. Let's start with the former first.

The US was the first to mass educate its population, it had excellent technical colleges, the GI bill after WWII was revolutionary and its top universities are the best in the world (still). Its innovation system, where universities and research institutes have good relations with business, has been a model for many countries to follow. The country is pervaded by a can-do mentality and bankruptcy isn't necessarily the life-long burden it is elsewhere.

The government was sponsoring fundamental research, research with the widest possible applications, which shouldn't be owned by any single company as many companies should get in on developing different aspects. This they did through universities and defense (DARPA). The innovation system in the US was, and continues to be, top notch, the envy of the world.

On the demand side, the US is blessed with a large internal market, where producers could reap important economies of scale and scope. Even if other markets are growing faster now, the US market is still the largest in the world today (the EU single market is still a work in progress, especially for services).

That huge American market was driven by domestic consumption (unlike today's China, which is much more investment and export driven). For decades, the US consumer was the proverbial consumer of last resort. Whenever the world economy got into trouble, as long as America started to consume again, things would turn out okay.

The size of the domestic market matters. Jeff Madrick wrote a convincing book titled 'Why Economies Grow,' in which he argues that the size of the domestic market has been the decisive factor in economic leadership in history. This passed from Spain to the Netherlands to Great Britain to the US, to a large extent because the size of their markets allowed for a finer division of labor, economies of scale and scope, allowing producers to recoup the fixed cost of technology development.

End of consumption led economic growth?

But just as China has to rebalance economic growth toward more domestic consumption and away from investment (export dependency adjustment is already well on its way), the US has to rebalance its economy away from personal consumption.

It looked like this was going to happen as a result of the financial crisis. Households were deleveraging, paying off debt which was left after the collapse in house prices left them with enormous mortgage debt and they had to repair their balance sheets (or at the minimum, there was a wealth effect operative).

However, the latest GDP figures show that this deleveraging process might already have come to an end:

In 2011, growth in personal consumption expenditures accounted for 1.54 percentage points of the 1.7 percentage points of economic growth. In the first quarter of 2012, they contributed 2.04 percentage points to the overall growth rate of 2.2 percent. Translation: The level of consumer activity is rising and driving growth to a much greater degree than it was last year. [Daniel Gros]

The somewhat curious thing is that public spending, despite all that talk of a "government out of control," was a considerable drag on the economy.

So in 2011, declines in government consumption sapped economic growth by .44 percentage points. But in the first quarter of 2012, contraction in the government sector took a bigger bite out of growth-subtracting .6 percentage points from the growth rate. [Daniel Gros]

But there was something more worrying:

The reduced savings rate, from $466.0 billion in the first quarter compared with $530.8 billion in the fourth (or 3.9 percent in the first quarter compared with 4.5 percent in the fourth), means more contribution to GDP in this measurement period, but it also means less stability for the long term. One of the problems of the economic boom from the 1980s through the 2000s was that it was build in part on a declining savings rate. [Anthony Randazzo]

Now, while those saving numbers are residual and therefore a little dubious, if confirmed this would be a worrying trend. Low savings is one of the things that got us into trouble. On the other hand, adjustment to a higher savings rate will, if nothing compensates the move, produce a recession of epic proportions.

What could compensate higher household savings is increased business investment, increased net exports, and/or increased public expenditure, but none of this is happening.

Despite all that talk of a "government out of control," public spending was a considerable drag on the economy.

So in 2011, declines in government consumption sapped economic growth by .44 percentage points. But in the first quarter of 2012, contraction in the government sector took a bigger bite out of growth-subtracting .6 percentage points from the growth rate. [Daniel Gros]

And why would business invest more when they already have overcapacity and demand for products and services would decrease as a result of increased household savings?

So any adjustment process towards more household savings is going to be extremely painful economically. However, we believe that there are structural shifts in the economy that will nevertheless make it happen. There were several waves of increases in consumption that now seem to have run their course:

  • Babyboomers are retiring
  • The great expansion of double income families is now in retreat (as a result of the employment crisis)
  • The 'democratization of credit' has produced such excesses that it will take considerable time to get us there again
  • Houses are no longer considered the safe piggybanks from which equity could be withdrawn at will

One big uncertainty is what will happen to ever increasing income inequality, as this has been a big driver for credit demand. If median wages remain near stagnant as they have been for several decades, either consumption will fall as most of the additional income that is created is going to the top which proportionally consumes less, or new forms of credit will be developed to 'remedy' this.

That doesn't seem very sustainable. The shift from low to high earners and from labor to capital cannot go on forever. It's no wonder most households are saving so little. They've shared very little in the wealth creation since the 1970s.

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The US has enjoyed a century of unprecedented growth, but part of the model on which this is based is running out of steam. Structural shifts will notch the economy away from the near complete reliance on household consumption, but that adjustment process is going to be very painful if nothing replaces the decrease in demand, already way beyond what the economy can produce as a result of the financial crisis.

While public spending in the US is low compared to other developed countries, there seems little appetite for an increase and the budget deficit is already very large anyway. But alternatives to fill the demand hole aren't very likely. Business isn't going to spend more in the face of lower demand and exports depend largely on the world economy.

We have long argued that some sort of restoration of 'Fordism,' that is, restoring the link between wages and productivity growth is necessary. But that would require a shift from the present low wage driven growth and seriously addressing the rising inequality. At present, the top 1 percent gets a disproportional part of additional income created (93% in 2010!).

But much more would be needed for such a recalibration of the US economy, like a wholesale overhaul of the secondary education system. We'll leave that for some other time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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