And Slower We Go
The news this week has been mediocre at best. That’s the most optimistic I can get over the data released yesterday and today. Manufacturing activity is now slowing down from the peaks of early this year, household incomes are flat, consumption has hit a wall, disinflation gathers pace, and savings are way too high.
Not good.
It is very clear that the second quarter, which as a whole was way down on the previous couple of quarters, ended on a very soft note. More a whimper in fact.
Not good at all.
We could still survive without another downturn, the Fed certainly seems to think so, but there are increasing signs of unease in the credit markets: bond prices are beginning to signal the need for help if we are to avoid that dreaded ‘double dip’.
Consumption, Incomes, and Savings:
Personal incomes ground to a halt in June, with a zero change over May. This is the first time in a year that there has been no growth in personal incomes, and the report came as something of a shock: most people were expecting growth of around 0.2%. Worse still, the figures for both April and May were revised downward, indicating that the weakness in June had set in earlier. The real damage to incomes came from private sector wages which declined 0.1% in June. Whether this is a portent of deflation we cannot yet tell, but it is an ominous sign that the economy is failing to achieve any private sector momentum.
Naturally this slowdown showed up in consumption spending which was also virtually flat for June, with growth of only 0.1% after adjusting for inflation. The only bright spot was in durable goods – high ticket, long lived products – spending. Since durable goods are notorious for being susceptible to cycles, June’s modest strength suggests to me that consumers were making purchases they had been postponing for a while. It will be interesting to see whether the trend develops or fades later in the year. Other sectors of demand, for non-durable goods and services, were both weak and in line with incomes.
This lack of spending had an impact on savings. The savings rate rose to 6.4% in June, and May’s rate was revised up from 4.0% to 6.3%. Consumers are clearly hunkered down in fear, which is, of course, the root cause of all our troubles.
As long as consumers, and businesses, fail to spend, the economy will sputter to a halt. There is enough energy out there at the moment to keep things in the black, but a few more months of this tentative nature and we can no longer guarantee GDP growth. The limit will probably be reached in late fall or early winter. Only then will we know whether the economy can pull out of this dive without slipping into another contraction.
Inflation:
The ongoing slowdown in the rate of inflation – aka disinflation – continues. Consumer prices fell 0.1% in June, if we exclude the more volatile things such as energy and food costs, it was unchanged. This brings the rate of inflation for the past twelve months down to 1.4%, well below the Fed’s target of a 2.0% ceiling. And the trend is downward.
This is simply not good news.
As I have argued here before we appear to be getting all too close to outright deflation, which is something we want to avoid at all costs.
Deflation is pernicious. It reduces consumption because people put off buying things in order to wait for lower prices. While that may appear to be a good thing – lower prices seem to be beneficial – it actually undermines the economy by sucking consumption out and overemphasizing savings. This is exactly the Japanese syndrome, where an economy becomes entirely dependent on outside assistance for its survival. The Japanese unwillingness to spend has not been a disaster only because other countries, notably the US, have been willing to do so. Left to its own devices the Japanese economy cannot sustain a healthy level of employment because the Japanese themselves simply don’t spend their incomes. What growth there has been for the last two decades has been driven by exports.
Not only does deflation undermine consumption, but it has the same effect on investment. Businesses are perpetually driven to postpone major expansion because their expectations of future sales are shrinking, not growing. So there is no incentive to build more factories or employ more people.
Lastly deflation also undermines the credit markets. On the surface it looks as if the losses suffered by borrowers – they have to pay back loans with money whose purchasing power is far greater than that they borrowed – would be offset by the profits to lenders. But this is not true. Prospective debtors realize that they would experience this loss in wealth every time they borrow, so they simply stop borrowing. This cramps growth, and it leaves lenders with cash unused. Since that cash is rising in value simply by being unlent, the entire banking system grinds to a halt. The economy ends up being awash with cash that no one wants to use.
The only time deflation is a benefit is during periods of immense productivity gain, when the fruits of new technologies drive down prices of some goods and thus release spending power for application on other goods or services. A prolonged burst of productivity is, in fact, the only way that long term living standards can be increased. This is as long as the increased productivity finds its way into wage growth and not simply profits. If we reflect on the state of US manufacturing or agriculture, a major reason that we employ far fewer workers in those sectors has been the enormous increase in productivity of the remaining workers. This productivity gain comes from the use of new technologies and the substitution of machinery for human labor. There is, of course, a point at which no amount of capital substitution can offset the existence of low labor costs elsewhere. This latter point is why China now dominates world manufacturing: its workers earn about 3% of the wages of their US counterparts. That advantage is so large it cannot be overcome. Naturally this dichotomy will change through time as Chinese workers seek to raise their standard of living and demand a greater share of the profits now being reaped by Chinese capitalists.
Ironically, such a shift in Chinese wage rates would then flow into the US as higher prices and return us to an inflationary rather than deflationary path.
Until then deflation seems to be our emerging issue.
Parenthetically, the world credit markets are fairly screaming this point at the moment. For all the recent talk of inflation fears and the need to tighten government spending because the bond market ‘expects’ or ‘wants’ balanced budgets, the evidence is exactly the opposite. More and more it looks as if the bond markets are concerned over renewed recession. The damage done to asset values by weak or declining GDP is greater than that done by huge government borrowing. The credit markets realize this and are pricing bonds and other assets accordingly. Bond rates, far from crying out for restrictive budgets, are calling for more effort to stave off recession.
Not that we could tell from the words of officials who all seem to have fallen into the worst kind of groupthink. It is now fashionable to be a deficit hawk and call for stringent and punishing cuts. No matter what the cost to growth and wealth. We are now intent on passing along a diminished economy and highly damaged opportunity as our legacy.
Presumably because we lack imagination.
Manufacturing:
The Institute of Supply Management report on manufacturing activity also points to a slow down. But not a downturn. The ISM index stood at 55.5% in July which is the fifteenth month in a row that the index has been above the magic 50% mark. Any reading above 50% points to expansion – more than half respondents indicating that they are adding to production in response to demand. So that is good news, but it is moderated by the fact that July’s reading is down from prior months. Activity was down from the early part of the year. We will have to wait to see if this downturn is maintained in light of the sluggish consumption figures I mentioned above.
What is clear is that this decline will feed into business expectations and act as a break on employment. A couple of weak months of data and businesses will be forced into a ‘wait and see’ approach as they plan for next year.
And that will generate more hesitancy. Which will lead to lower growth.
As I said: this week’s news has been mediocre at best.
