Wednesday, April 25, 2007

The American Nightmare

or "How To Spend Yourself to Death".

This if for Anon - who needs a real handle.

Ever increasing attention is focused on the state of the American economy. The general agreement seems to be the down turn is nigh, the only question most people are still asking how bad will it be?

One of the most commonly cited concerns is the US government budget deficit. The Bush lead spending programs – particularly military – are one of the main focuses. The key concern is the run up of the deficit and debt. The implication seems to be the American government is now over extended in its spending and cannot engage in any further stabilization or stimulation policy. Basically, people are arguing that the US can’t afford its current spending practices.

This isn’t entirely the case, not on government front. The US deficit peaked in the late 1970’s and early 1980’s. It finally returned to surplus under Clinton. Clinton managed to ride personal tax increases and increasing transfers to a surplus. The Bush administration has, however, reversed both these trends and started running deficits again. My objection to the spending is what the population is getting in return. Bush has also been enjoying relatively low debt service costs. The bottom line is that budget situation in the US has been worse in recent memory, and is only a cause for small worries - right now.

The real terror is not government spending at all. What gives me the sweats is the personal savings rate. For the first time since WWII the US personal savings rate is negative. This is the continuation of a trend for an extended period of time. The average American’s net worth is declining rather than growing. Americans are consuming more than they earn. This is a definite cause for alarm, particularly when combined with the government debt.

How can the average American consume more than they earn? There are essentially two ways.

1) Draw down savings and assets. This is partially driven by demographics. As people move from work to retirement they tend to dis-save. That is, they spend their accumulated wealth. To do this they generally sell financial assets.

Selling something means that somebody else must be buying. But if the average American is selling, who’s buying? It can’t be other Americans,l it has to be foreign citizens. The US citizenry is selling off its assets, both domestic and foreign, at an alarming rate. This has dramatic implications for future consumption possibilities.

This has been going on for years. The US has been running a Current Account deficit for decades. This has meant a draw down of American assets. What makes the current situation a cause for worry is the speed at which its happening and the nature of the spending that’s taking place. It won’t take long for the US to hit a capital ownership crisis at this pace. What happens when they run out of assets to sell?

2) The other method of financing consumption beyond income is to borrow. Due to current monetary policy in the US, borrowing is cheaper than it has been in generations. Automotive manufacturers are offering financing at 0%. It was not uncommon to see mortgage rates advertised below 4% a couple of years ago. The low interest rates were in large part driven by the policies of the Federal Reserve after 9/11. The goal was stimulate the economy to avoid a recession. Largely it worked, for now.

Here’s the problem with lose monetary policy. If you run it for too long you get high inflation – which nobody wants right now. This means that lose monetary policy must be temporary. People, businesses, and governments tend not to realize it is temporary when considering borrowing. As a result they tend to borrow more than is reasonable. The problem arises when the interest rates do rise and the loan becomes unaffordable.

The other question is who are they borrowing from? A lot of the money that was lent to the sub-prime mortgage market was new money – part of the monetary expansion designed to keep interest rates low. The remainder of the funds have to be coming from outside the country. Again the US is transferring wealth abroad. The difference here is the payment will take place in the future, rather than today.

So why does all this mean the Americans are in real trouble? Simple, the sale of assets and borrowing is financing consumption not investment. Very little of the spending is going toward things that are going to expand consumption opportunities in the future. All they’re doing is transferring consumption between time periods, not generating more of it. The real problem will come when the younger American population figures out that they are going to have to reduce consumption to pay back what has been spent. I’m not sure what the response is going to be.

The best case scenario is this; with the US unable to consume a number of countries will be lead into recession, not just the US.

How hard the recession depends on how quickly lenders go after real assets and the response of the American consumer. My guess is it will be worse the ’91.


Anonymous said...

i to back to a more realistic economic equilibrium, a day of reckoning must occur.

also, i remember a valuable lesson once, that borrowing for operational expenses - ie: consumption in this case - and not for investment purposes spells disaster.

many are hoping for sustained increases in housing prices to cover any shortfall...but that doesn't make any sense unless you're American, borrowing to pay off other borrowing...

i remember '91, that felt like a 5 year recession, absoluteky horrible, and it will happen again, but here is where i differ from you a bit....NORTH AMERICA is in deep trouble but the rest of the world i think is becoming a bit delinked from us, and spells trouble for us...because while we are in recession, that doesn't necessarily mean everyone else is going to be, maybe slower growth, but not nothing bad as us.


economistatlarge said...

You're largely right about the rest of the world becoming less hocked into the American economy - including us.

But here's the biggest problem I see. The Chinese have been buying up American debt. The Chinese economy is also largely dependent on the American consumer market for exports. What happens to China when the US market dries up?

Actually, as I re-read this - that may be our saving grace. The Chinese will need a place to sell the consumer products they used to sell to the US and prices will fall. The question will be how quickly.

Anonymous said...

i was thinking about China too, but they're thinking about it too, and that's why they are slowly moving away from the US dollar (and by extension the US consumer).

Big problem: Chinese have been too successful...with so many $$$, it's going to take a very long time. For us, that's a big plus.

Another issue: when Chinese domestic technology improves (and it is), and they begin to diversify their economy away from the consumer crap you see at Wal-Mart and other places...that's when people should/must start to think more seriously.

When Chinese politics becomes a bit more open that it is today (not necessarily the foolish "democracy" we have here - which doesn't work quite well anyway but that's for another day), then really watch out. Opening the system up allows for more people, more smarter people to enter into the fray, then and only then will the world see the wonders of China, a country who was light years ahead of everyone in the past until a political system closed it inwards.

So while it opens up (ironically), i see North America closing up, fear of this and fear of that, in the name of security etc...We have seen that kind of logic work out in our recent past (Nazi Germany) and look where that took us.