Today’s news about October retail sales (-2.8% relative to the previous month and now down in real terms for five months in a row) confirm what this forum has been arguing for a while, i.e. that the U.S. has entered its most severe consumer-led recession in decades. At this rate of free fall in consumption real GDP growth could be a whopping 5% negative or even worse in Q4 of 2008. And this is not a temporary phenomenon as almost all of the fundamentals driving consumption are heading south on a persistent and structural basis. Consider the many severe negative factors affecting consumption. One can count at least 20 separate or complementary causes that will sharply reduce consumption in the next several years:
- The US consumer is shopped-out having spent for the last few years well above its means.
- The US consumer is saving-less as the already low household savings rate at the beginning of this decade went to zero/negative by 2006 and has now to raise to more sustainable levels.
- The US consumer is debt burdened with the debt to disposable income having increased from 70% in the early 1990s to 100% in 2000 and to 140% in 2008.
- Not only debt ratios are high and rising but debt servicing ratios are also high and rising having gone from 11% in 2000 to almost 15% now as the interest rate on mortgages and consumer debt is resetting at higher levels.
- The value of housing wealth is now sharply falling by over $6 trillion as home price depreciation will soon be 30% and reach a cumulative fall of over 40% by 2010. Recent estimates of this wealth effect suggest that the effect may be closer to 12-14% rather than the historical 5-7%. And with home prices falling over 30% about 40% of all households with a mortgage (or 21 million out of 50 who have a mortgage) will be
under water (negative equity in their homes) with a huge incentive to walk away from their homes.
- Mortgage equity withdrawal (MEW) is collapsing from $700 billion annualized in 2005 to less than $20 in Q2 of this year. Thus, with falling housing wealth and collapsing MEH US households cannot use their homes anymore as ATM machines borrowing against them.
- The value of the equity wealth of US households has fallen by almost 50%, another ugly wealth effect on consumption.
- The credit crunch is becoming more severe as the recent Q2 flow of funds data and the Fed Loan Officers’ Survey suggests: it is spreading from sub-prime to near prime to prime mortgages and home equity loans; and from mortgages to credit cards, auto loans and student loans. Both the price and the quantity of credit are sharply tightening.
- Consumer confidence is down to levels not seen since the 1973-75 and 1980-82 recessions.
- Real wage growth and real income growth has been stagnant in the last few years as income and wealth inequality has been rising. And now with GDP and real incomes falling real consumption will fall sharply.
- The Fed is reaching the zero-bound on interest rates as the economy gets close to deflation given the slack in goods, labor and commodity markets. Deflation means that consumers will postpone consumption as future prices are lower than current prices, as real rates are positive and rising and as debt deflation increases the real value of the households nominal debts
- Employment has been falling for 10 months in a row and the rate of job losses is now accelerating. In the last recession in 2001 that was short and shallow (8 months from March to November 2001 with a cumulative fall in GDP of only 0.4%) job losses continued all the way until August 2003 with a job loss recovery and a total cumulative loss of jobs of over 5 million from the peak. In this cycle job losses have been so far “only” slightly over 1 million while labor market conditions are severely worsening based on all forward looking indicators such as initial and continuing claims for unemployment benefits. Massive job losses and concerns about job losses will
further dampen current and expected income and further contract consumption.
- Tax rebates of over $100 billion failed to stimulate real consumption earlier in 2008. Only 25% of the tax rebate was spent as US consumers are worried about jobs and need to use funds to pay their credit card and mortgage. The tax rebate was supposed to boost consumption all the way through September 2008: in reality real retail sales and real personal spending rose only in April and May while starting in June and all the way in July, August, September, October and now into the holiday season real retail spending and real personal spending are down month after month. Thus, another general tax rebate would be as ineffective as the first one in boosting consumption.
- The 1990-91 and 2001 recessions were not global; this time around the IMF is
forecasting a global recession for 2009.
- The recent rise in inflation – that is only now slowing down – reduced real incomes even further for lower income households who spend more than the average households on gas, transportation, energy and food. The recent sharp fall in gasoline and energy prices will increase real incomes by a modest amount (about $150 billion) but the losses of real disposable income and thus falling consumption from other
sources (wealth, income, debt servicing ratios) are much larger and more significant.
- The trade weighted fall in the value of the U.S. dollar since 2002 has worsened the terms of trade of the US and reduced further real disposable income and the purchasing power of US consumers over foreign goods.
- With consumption being over 71% of GDP a sharp and persistent contraction of consumption all the way through at least Q4 of 2009 implies a more severe recession than otherwise. Consumption did not fall even a single quarter in the 2001 recession and one has to go back to 1990-91 to see a single quarter of negative consumption growth. But the worsening balance sheet of US consumers in 1990-91 (debt ratios, debt servicing ratios, employment contraction, wealth effects of housing and stock markets) was much less severe than the current downturn.
- Monetary easing will not stimulate durable consumption and demand for residential housing as demand for such capital goods becomes interest rate insensitive when there is a glut of capital goods; monetary policy becomes like pushing on a string. In the previous recession the Fed cut the Fed Funds rate from 6.5% to 1% and long rates fell by 200bps. In spite of that capex spending of the corporate sector fell by 4% of GDP between 2000 and 2004 as there was a glut of tech capital goods and it took years to work out such a glut. Today there is a glut of housing, consumer durables and autos/motor vehicles; so it will take years to work out this glut and monetary
policy is becoming ineffective to resolve that glut.
- While policy rates are sharply falling the nominal and real rates faced by households are rising rather than falling: rising mortgage rates (and event near lack of any mortgage financing at even higher rates for sub-prime and jumbo loans), rising rates on credit cards, auto loans and student loans together with less availability of credit are severely dampening the ability of households to borrow and spend.
- To bring back the household savings rate to the level of a decade ago (about 6% of GDP) consumption will have to fall – relative to current GDP levels – by almost a trillion dollar. If all of this adjustment were to occur in 12 months GDP would contract directly by 7% and indirectly (including the further collapse of residential and corporate capex spending in a severe recession) by 10%, an exemplification of the Keynesian “paradox of thrift”. If such an adjustment were to occur over 24 months rather than 12 months you would still have negative GDP growth of 5% for two years in a row with a cumulative fall in GDP from its peak of 10% (note that in the worst US recession since WWII such cumulative fall in GDP was only 3.7% in 1957-58). One can thus only hope that this adjustment of consumption and savings rates occurs only slowly over time – four years rather than two. Even in that scenario the cumulative fall of GDP could be of the order of 4-5%, i.e. the worst US recession since WWII. Note that the cumulative fall in GDP in the 2001 recession was only 0.4% and in the
1990-9 recession was only 1.3%. So, the current recession may end up being three times as long and at least three times as deep (in terms of output contraction) than the last two and worse than any other post WWII recession.