household debt

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Weekend Round Up

It’s been a busy week. Particularly for sundry European leaders. Here’s a few suggestions for your consideration over the weekend.

Are stock markets really that stupid?

The extraordinary jump in the world’s various bourses at first sight of the Euro “solution” was out of proportion to the likely success of said solution. Actually it isn’t really a solution at all. It is a heavily disguised punt. None of its key features are what they seem. The haircut on the debt is voluntary. A hair cut is a great idea: let’s face it the Greek debt is nowhere near as valuable as the numbers the banks are carrying on their balance sheets. I would guess it’s worth about 20% of that carrying value. Nonetheless a 50% hair cut gets us closer to reality. The problem is that the hair cut is voluntary. There is no enforcement.

Why not?

Because to make the hair cut involuntary would open the door to the deal being called a default – as it it isn’t already. That is an odious word in the fantasy land of banking. A default would trigger all sort of doomsday activity, most of all in the credit default swaps market. The banks, you see are all terribly clever: they take on risk assets in order to make a profit from the risk, but then insure themselves against any losses from that risk by buying credit default swaps. Which they naturally buy from other banks. So the risk is shunted about within the banking system and ends up … who knows where? The world’s regulators have let this “pass the buck” activity grow so far out of control and undocumented properly to boot that everyone is terrified of what would happen were the banks to start making claims on this insurance. The losses implied by the hair cut could rumble about the system and destabilize banks in every corner of the globe. So no one wants to trigger a default, lest we unleash a second coming of the Lehmann debacle.

Here’s the silliness of this: the banks would thus have to book larger losses. Or at least those whose risks are properly offloaded. So, why in heaven’s name would they voluntarily take a hair cut? They would end up worse off.

But no one wants the hair cut to be involuntary.

Oh, what a tangled web the banks have us caught up in.

A second part of the Euro solution is it’s rescue fund. Hitherto that fund has been far too small to cope with the bail out of debtor like Italy – the world’s third largest issuer of sovereign debt. It can cope with small fry like Greece, but not the bigger nations now being sucked into the Euro collapse vortex. As the markets slowly realized this, the orthodox view became the rescue fund needed to top a trillion Euros. For some reason this magic number was seen as sufficiently large that it could act as a firewall: the crisis would crash against that bulwark and then ebb away as investors realized there was enough cash to keep the market alive.

So, hey presto, the negotiators conjure up a fund of over one trillion. The market heaves a gigantic sigh of relief and rages upwards. But. That magical figure is an illusion. It is the result of a proposal rather than a check arriving. The proposal is to – get this – leverage up the existing fund. Yes the bulwark against the debt crisis is the same leverage trick that sank Lehmann.

Whether the private sector can produce the debt implied in this plan I doubt. Especially when the furor dies down.

Meanwhile the most glaring deficiency in Europe – the lack of a clear lender of last resort – goes unaddressed. That means, in my view, the crisis will perk back to the boil as the next few months go by and everyone realizes that continent wide austerity is making debt problems worse

Governments cannot create jobs, but they can destroy them.

Poor Krugman. He’s beside himself this morning. I sympathize. The Republicans, whose mantra has been that the government cannot create jobs through spending – rubbish, but let’s ignore that for now – are apoplectic at the thought of all those job losses implied by cuts to defense spending.

Say what?

I admire the Republicans for having the nerve even to try this particular example of contorted mental gymnastics. It takes a very special mind to reason that defense spending is somehow not the same as any other kind of government spending. The thought is this: when the government hires a teacher, that is not job creation. When the government hires a soldier, that is most definitely job creation. More to the point: paying to build a school does not add to the economy and does not employ people. Building missiles does both. Ugh.

This twisted thinking sets a new low standard for even our political class. Yet here we are: the Republican leadership is all atwitter over the enormous damage to our unemployment problem were we to cut the offense defense budget. Just think of all those unemployed missile makers and generals. The horror. But slashing police, firefighters, and teachers from the payroll, which is what cutting domestic government spending amounts to, is somehow just fine.

There are words to describe this nonsense, but I defer using them for fear of hurting your ears.

Consumers to the rescue!

Well no, but if you are a breathless stuffed-shirt cable television expert it sounds nice to say so.

Today we learned why, or at least how, the third quarter GDP figures were as strong as they were. Don’t forget I don’t consider them strong at all. It turns out that in September, consumers spent way more than they earned. The savings rate dropped to 3.6%, it lowest since late 2007, while personal incomes rose a miserly 0.1%. Meanwhile consumer spending jumped 0.6%.

That doesn’t look like a sustainable trend to me. It looks very much like an end of summer blip.

It isn’t exactly rocket science to argue that spending cannot outstrip incomes for too long before we find ourselves back in a debt created mess again. Given that all signs indicate households are still trying to cut debt and not acquire it, the September reversal in the savings rate should be an aberration.

The implication is that the uptick in the GDP consumption category, which as you may recall was the biggest single reason for what growth we saw in the third quarter may ebb away as winter arrives. This means the other categories within GDP will have to take up the slack. Since none appear likely to do so, I think it fair to predict that the third quarter is not the start of a steady increase in activity, but is, more likely, simply another bump in a long list of such bumps along a stagnant road.

Which is what I have been trying to argue all along.

One last thing:

Back to Europe …

Fitch, one of the top rating agencies, says the Euro deal is good for Europe.

This means the deal is almost certainly not good for Europe.

Recall that Fitch, like the other ratings agencies, told us that those Mortgage Backed Securities were just amazing. Their brilliant analysis led them to go along with the magic wand trick that turned sub-prime into, not just prime, but AAA prime assets.

These people cannot be trusted to turn a calculator on correctly, let alone actually use one properly.

This is one group of folks whose recent body of work indicts their professional standing. It calls into question their ethical standing too, but that I will leave alone for now. Suffice to say Wall Street is hardly center of virtue.

But you know that already.

Enjoy the weekend.

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Productivity and Its Place In Our Story

The stock market is rising strongly today after yesterday’s plunge. I won’t bother to dignify this extraordinary oscillation with a comment other than to say that anyone who believes stock’s are “efficiently” priced has a lot of explaining to do. Precisely what, I wonder, is so positive today that it can offset yesterday’s negativity. More to the point, how come that positive news was unknown a mere 24 hours earlier? But as I said I won’t ask those questions.

What we can do, however, is to take a short break from bemoaning the absence of leadership in economic policy to reflect on yet another poor number: productivity seems to have tanked recently.

This morning’s data are far from rosy: productivity declined 0.3% in second quarter, while it was revised to a decline of 0.6% in the first quarter from what had originally been reported as a 1.8% gain. This is not good. This makes two successive quarters of decline which we hadn’t seen since 2008. Moreover, productivity has crawled up a mere 0.8% over the past twelve months, which is another bad performance and a sign of things being out of kilter deep within the economy.

The irony is that the weakness in productivity is coming from rising unit labor costs. Before you all fall off your chairs, let me remind you that unit labor costs are not simply a reflection of wages, but are, as they sound, a measure of the cost per unit of output – a ton of steel for instance. So if the labor effort rises more rapidly than output, productivity falls. In the longer term this cramps the space available for profit and wages, which is why we pay attention to productivity in the first place. But it is also something that is devilishly difficult to calculate, especially in service industries. Exactly how do we measure the unit cost of a legal brief? And what, exactly, is the output of a legal brief? Stop chortling, these are important things to consider, especially in an economy like ours which is heavily skewed towards service industries.

What appears to be going on at the moment, by which I mean the last six months, is that output has not risen as fast as the effort going in. And the cost of the effort going in is not a function of rising wages as much as it is a reflection of the extra hours being worked. In fact real wages – wages adjusted for inflation – are falling, by as much as 2.1% last quarter.

The problem with untangling the story from the numbers is that we can give two equally plausible accounts, but which contradict each other in a more general context.

First: productivity could be falling because businesses misjudged demand and over-hired relative to what they ended up needing to produce. According to this view we should expect that companies retrench and trim hiring to get back into a better, more profitable, balance. Or, second, businesses may have misjudged an increase in demand and have had to hire workers at a greater rate, implying that future productivity reports will reflect a better balance at a higher level of activity – the adjustment needed for those new workers to produce at an efficient level being the ongoing factor distorting productivity currently. This more positive view suggests we should see more hiring as businesses calibrate activity against unexpectedly large demand.

Naturally we need to look at other statistics in order to select which of these two narratives is the more likely explanation, and, unfortunately, I suspect we are led to choose the negative over the positive.

Why?

Because it fits well with our overall narrative that the economy has approached a stall velocity and that demand is weaker than many people – although not us – expected. As we slog through this part of the annual planning cycle in business we can surmise that the outlook for 2012 against which businesses will array resources is less hopeful than it was a year ago. This will exert caution. Budgets will be restrained, if not cut. New hiring will postponed as current staffing levels are re-assessed. And, in general, activity will be based against lower expectations.

Any economy wading its way through a major balance sheet adjustment, as ours is, will grow both fitfully and slowly. There will be many episodes of reappraisal as both households and business cast wary glances at each other. Households fear unemployment and face the risk generated by not being able to support debt loads. So they look for ways to trim expenses and pay off debt, rather than spend. Extra income is channeled towards debt reduction and does nothing to boost demand. This is a major factor why tax cuts have little stimulative impact: people save them. This attitude on the part of households causes business to predict weak demand, and so annual budgets reflect weak hiring and investment requirements. It may well be that, as is the case now, businesses are flush with cash. But they see no profitable investment opportunity other than to save labor costs by replacing labor with machinery. Cost cutting becomes even more a vogue in these circumstances and so households, in turn, worry even more. And so it goes.

Within this negative cycle there can often be moments of what appear to be recovery. Households and business both need to replace worn out things so not all spending can be postponed forever. Thus, even in a debt crippled economy, there can be quarters of growing demand. But that growth quickly dissipates as the longer term retrenching trend re-asserts itself.

It is this search for a solid footing with respect to debt levels that is dominating our economy. Our private sector is disgorging debt. It can do that through default which is the process we are still seeing in housing. Or it can take the much slower route and pay down debt from income, which is a trend we are seeing in aspects of consumer credit. This latter process is particularly difficult at the moment because incomes are not rising quickly, if at all, and inflation is very low, so the inflation burden of debt remains high. Getting average earnings to rise, or allowing a bout of inflation would both accelerate our recovery. Unfortunately neither looks likely.

Those of us who look at the economy through the prism of debt and balance sheet adjustment are not at all surprised by the recent string of bad news. It was always the more likely outcome. Policy has not been anywhere near sufficient to deal with the root causes of the crisis: not in terms of stimulus; not in terms of debt relief; not in terms of bank reform; and not in terms of enforced loss recognition. Policy makers seem to have viewed this recession/depression as yet another typical post-war recession. This was a gargantuan error. The accumulation of mistaken policy decisions, up to and including the US austerity effort, is making it harder to conclude the adjustment process. So we are faced with years of unnecessary malaise and uncertainty.

This narrative is a long way from the productivity report I began with, but, hopefully, you can see that, when viewed through the lens I have described, nothing in that report, or any of the other recent reports should be a surprise.

Expect more like them.

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Debt Conundrum

What I am about to say is not novel, but nor is it trite: if the austerians – the word we now use to describe those who advocate cutting public spending and debt – really believe that a reduction in public spending can spur, without doubt, economic growth, then the gap opened up by that reduction must be more than filled by something else.

So what is that something else?

Well, a sudden shift in trade could do the trick. That means a sudden expansion of US exports so that the US trade balance zooms from a sea of red ink towards being securely in the black. Canada managed this solution when it had budgetary difficulties. As did Sweden. Somehow I see this as unlikely here. Our appetite for oil sets a fairly high threshold for us to jump over, and the dollar would need to drop some more. With world oil prices moving higher, and not lower, the degree of difficulty is increased. At least near term.

And where would these exports go?

The data suggests there are only three viable trade partners to absorb enough US goods: Europe, Japan, and China. The Euro zone as we know is not in too good a shape, and has already reduced its trade imbalance with the US. The other two are more problematic. Japan is in all sorts of difficulties as result of the recent disaster, its economy is weakened in the short term, and any recovery there may not support a boom in US trade. That leaves China which continues to resist strong currency adjustment and thus blunts the possibility of a US trade surge.

So, even though the world economy is growing at a decent clip, it is not at all clear US exports are about to take off sufficiently to plug the gap opened up by reduced government spending.

So that throws the spotlight onto the private sector.

There we have two possibilities: investment and consumption.

I have berated big business enough times for you all to realize that I am highly skeptical about the probability of investment suddenly rising to the task of leading an economic charge. Business is awash with cash; profits are at very high levels – last year’s profit growth was the best since 1950 – and still investment is more of a dribble than anything else. Indeed the latest numbers suggest companies have reached a plateau in most forms of investment, and are now sitting around waiting to see if demand picks up enough to justify a second installment. The recent durable goods data shows a definite flattening out of growth in investment. There doesn’t seem to much else on the horizon.

So despite all that idle cash waiting to be deployed into productive activity, business investment is much too slow to offset the imminent reduction in the economy planned by the austerians. Every day that pile of cash goes unused the more the opportunity lost costs money. Since I don’t believe business willingly leaves profits on the table uncontested, there must be something preventing action. Clearly the business world is nervous about something.

And that something is the shape of household demand.

Which gets us to the center of our dilemma.

The current outlook for households is not exactly rosy. Wages are flat, indeed when the impact of inflation is accounted for they are going in the wrong direction. The job market still casts a pall across the economy, and causes enough anxiety to restrict much free spending. Home prices have dropped and caused a perceived need to replace that loss on household balance sheets with other assets. That means savings need to rise at least temporarily. That implies a decline, or at least a flattening out, of consumption. So little growth is likely from this quarter.

We have reached an impasse: none of the potential sources of replacement activity seem likely to play that role. Thus, a decline in public spending inevitably will lead to a smaller economy. GDP will decline from its current path. Whether that decline will be large enough to push us into recession I doubt. But it will be enough to throw us into a potentially endless sideways movement with constant high unemployment, and ugly performance in most important categories of activity. Stagnation beckons.

Unless.

Unless we go through a great boom in private debt.

Yes. That’s right. The only way the austerian project is viable is if household debt levels grow sufficiently to provide the spending power needed to offset the lost government spending.

This is truly perverse.

After berating us all for reckless borrowing and the damage it did to our economic stability, the austerity police are now relying on us plunging more deeply into debt so that they can cut public debt without cutting the economy. They just don’t want to admit it. Their entire plan relies on pumping private debt up beyond where it is currently. This does not mean that those folks who went into debt too deeply before have to return there. It means that others, people with healthy balance sheets, people who don’t normally borrow, and people who have cash anyway, all have to fill the void. As the crisis abates and the cleaning up of the bad debts accumulated back in the bubble are worked off, the austerians assume there is a pool of new borrowers waiting to jump in and provide the boost we need.

Some of this borrowing could come, I suppose, from businesses tapping into the banks and credit markets. But, as I said, business is awash with cash. Business doesn’t need to borrow. Besides they don’t seem keen to spend.

No. This increase in debt has to come from households. Especially those who sat out the last boom in debt.

Is this likely?

You answer that one.

I don’t think it is.

That means the austerity programs being shoved into place can have only one impact: they will contract the economy. Demand will fall. It isn’t too large a government budget that scares business into hoarding its cash. It is too small a government. Every dollar cut from government spending is a dollar less flowing through the pockets of business, both large and small. That means fewer jobs, not just because we fired a bunch of teachers or firefighters, but because we drained demand from the private sector and thus reduced the need to hire workers.

Expectations play a key role in the economy. As long as the austerians scream panic and cut, those expectations will tend towards being negative. This is the exact opposite of what the orthodox economists would preach. But they’re wrong anyway.

We have a debt conundrum: the fiscal conservatives are advocating fiscal recklessness. They just don’t want to say so. Then again, these are the same folks who brought us the Reagan and Bush deficits. So we should not be surprised. Not surprised at all.

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Good News: Retail Sales

You all know my mantra about one month of data not being a trend. Well what about two months? This morning’s release of the November retail sales data brings us good news: they rose by 1.3%. This follows October’s revised increase of 1.1%. So two months in a row? Is this a trend?

It’s beginning to look that way.

Even if we take out volatile stuff like auto sales the increase remains, albeit much smaller at 0.64%. Plus, with the exception of clothing, sales seem to be picking up right across the board. Keep this up and we will can look forward to a much brighter 2010 than we had previously thought.

Backing this up is the fact that consumer sentiment, as measured in the monthly University of Michigan survey, also jumped up from 67.4 to 73.4 in recent weeks. Clearly at some level people are beginning to emerge from their bunkers and get back on with life.

This is all going on in the context of continued consumer balance sheet retrenchment: consumer debt has fallen five straight months and is now down to 124% of disposable income. The third quarter reduction came in at an annual rate of 2.6%, a record, and clearly signifies the determination of households to get their books in order. This augurs well for the economy in 2010, because the sooner consumers can re-establish their fiscal well being the sooner they can begin to consume at levels necessary to fuel expansion. Household net worth is well off its peak set back in 2007, but the $2.67 trillion gain in the third quarter substantially reduced the loss since that peak – we have about $12 trillion left to go before we get back to the top. Obviously most of the drop in net worth is a result of the fall in home prices, but the recent recovery in the stock market and the very slight pick up in real estate has reversed the decline.

So today’s news can only be interpreted as good.

The only remaining issue, and it’s a big one, is unemployment. If we can break the back of long term unemployment then we can be so much more confident about the next few years.

Assuming we fix the banking system, but that is another matter.