The Daily Reckoning
Paris, France
Thursday, June 1, 2006
The Daily Reckoning PRESENTS: It is a common refrain in economic reports that government borrowing tends to crowd out business investment. But, as The Good Doctor points out, its logical correlative that consumer borrowing must essentially have exactly the same negative effect on business investment is never mentioned. Read on...THE U.S. CONSUMPTION BIASby Dr. Kurt Richebächer
SourceIn general, the high esteem of American policymakers and economists for consumer spending as the motor of economic growth is attributed to the influence of Keynes. In reality, it originates in the early 1920s, long before Keynes, in America itself. American Keynesians later ascribed it to Keynes.
This thinking originates in a bizarre episode involving leading American economists. In the early 1920s, two until then completely unknown persons began to write a whole series of books that all propagated the idea that the capitalistic economy was chronically threatened by a lack of consumer income and demand. Their names were William Trufant Foster and Waddill Catchings.
Their writing attained the widest circulation in the United States and was accepted in universities. Among the books they published between 1923-28 were titles such as Profits; The Dilemma of Thrift; Money; and Business without a Buyer. In all these books, they warned of the danger of deflation and agitated for monetary inflation and public works.
To quote two typical remarks: “Money spent in the consumption of commodities is the force that moves all the wheels of industry” and “The one thing that is needed above all others to sustain a forward movement of business is enough money in the hand of consumers.”
The pair gained particular fame through a campaign that they launched with the explicit intent to “convert economists” by offering a prize for the best adverse criticism of their book Profits. An illustrious jury - among them America’s top economist professor, Wesley C. Mitchell, and Owen D. Young of “Young Plan” fame and chairman of General Electric - was to choose the best essay.
Among the authors of the essays were 50 professors of economics, 40 authors of books on economics, 60 accounting experts, bankers, editors and some of the “ablest men in the Federal Reserve,” etc. A later published collection of the essays revealed that all authors, except two, had unreservedly accepted the main thesis of Foster and Catchings that there exists a chronic bias in the economy toward a chronic deficiency of consumer purchasing power. Any objections were directed against minor details. (This episode is described in great detail by Friedrich Hayek in Profits, Interest and Investment, London, 1939.)
They proposed for every crisis a (for the time) revolutionary solution: “It would be easy to arrange an increase in consumers’ credits; it is only in this way that the deficiency in purchasing power of the consumer, and thus the cause of the Depression, can be removed.”
We have recalled this episode because it is widely unknown. On the other hand, it strikingly reveals that the American high esteem of consumption as the motor of economic growth has a long tradition. But in particular, it attracted our interest in view of the fact that the U.S. economy in the late 1920s went with an orgy of wealth-driven - the bull market in stocks - consumer credit into the Depression.
Thinking about the business cycle and the possible regular causes really started only at the end of the 20th century. As industrialization progressed, investment spending and employment in the capital goods industries also played a rapidly growing role. A few economists, at first, identified and pointed out the importance of variations in business investment in determining economic activity.
What finally revolutionized thinking about the business cycle and economic growth in Europe was a book from a Russian professor, Dr. Michael Tugan-Baranowski, titled Theory and History of Trade Cycles in England, published only in German in 1901. Based on a detailed study of British cycles and crises, he made several revolutionary statements, such as that the ultimate aim of production is not to improve living standards, but the creation of productive capital stock and the pursuit of profits by entrepreneurs.
As to the business cycle, he emphasized the overriding role of variations in the production of capital goods as compared with the even advance of the production of consumption goods. He also, for example, stressed that capital formation and production have their true limit in available saving, not in consumer spending.
Being written in Germany, the new business cycle theory virtually bypassed the English-speaking economists. Yet one admitted a strong influence. In his A Treatise on Money, published in 1930, J.M. Keynes explicitly stated: “I feel myself in sympathy with the school of writers - Tugan-Baranowski, Spiethoff and Schumpeter - of which Tugan-Baranowski was the first and the most original.”
In his book of more than 400 pages, Tugan-Baranowski analyzed in astonishing detail the various crises that the British economy and its banking system experienced during the 19th century. His conclusion was that every crisis arises from the fact during the boom and the following downturn the “proportional distribution of the productive forces is deranged.” Equilibrium of demand and supply is shattered. In the prosperity phase, some branches expand faster than others.
With Tugan-Baranowski, a new way of thinking about the business cycle began in Europe. It became the accepted central idea that economic growth and prosperity depend on autonomous capital investment guided by relative prices and profit expectations.
We have recalled these two episodes in the history of economic thought because they give food for thought about the present situation in the United States. Over the past few years, U.S. policies have boosted private consumption as never before in conformity with the conventional thinking that this must stimulate investment. Its true counterpart is the lowest level of business fixed investment.
It is a common refrain in the reports of American economists that government borrowing tends to crowd out business investment. But its logical correlative that consumer borrowing must essentially have exactly the same negative effect on business investment is never mentioned.
The policy dilemma currently facing the United States can be simply stated. Economic growth has become completely dependent on consumer spending, and this, in turn, has become completely dependent on rising house prices providing the collateral for the most profligate consumer borrowing. This borrowing has become a necessity because income growth has abruptly caved in. Rock-bottom short-term interest rates and utter monetary looseness were the key conditions fostering altogether four bubbles: bonds, house prices, residential building and mortgage refinancing.
What developed is an economic recovery with an unprecedented array of escalating imbalances: ever-declining personal savings; an ever-widening current deficit; exploding government and consumer debts; and, on the other hand, a protracted shortfall in business fixed investment, employment and available incomes.
We must admit that the staying power of this extremely ill-structured and debt-laden recovery and the stubborn buoyancy of the financial markets have rather surprised us. Under the prevailing conditions of rampant global liquidity excess, there has apparently developed an unprecedented and virtually unlimited tolerance for economic and financial imbalances. Consider that Iceland has a trade deficit of 16% of GDP.
But this only lengthens the rope with which to hang oneself. What American policymakers and most economists studiously keep overlooking is that the credit bubbles are doing tremendous structural damage to their economy. The longer the bubbles last, the greater the damage.
This time, we want to focus on the dramatic shortfall of employment and income growth that radically distinguishes this recovery from all its precedents in the postwar period. It must have a particular cause, but where is it? In search of its causes, we contrast, first of all, credit and debt growth with income growth.
Over the five years from 2000-2005, total debt, nonfinancial and financial, has increased $12.7 trillion in the United States. This compares with a simultaneous rise in national income by $2.1 trillion. For each dollar added to income, there were $6 added to indebtedness. In real terms, national income increased little more than $1 trillion.
These figures raise two paramount questions: First, what explains this unusually rapid credit expansion? And second, what explains the unusually sluggish employment and income growth?
The first question is the easiest to answer, because the overwhelming use of the extended credit is well known. In times of yore, the financial system in any economy served mainly to transform available savings into investment and to allocate those funds among competing users.
Today’s financial systems, and in particular that of the United States, have vastly outgrown this traditional role. Financial activity for purely financial purposes, outside the GDP, has gained overwhelming importance. Businesses are running a sizable surplus in their current transactions, yet they borrow heavily for asset purchases, buying growth through mergers and acquisitions. The single biggest item is certainly borrowing for leveraged asset purchases - carry trade.
Yet we see two further reasons for the continuous, extraordinary stampede into debt. One of rapidly growing importance is certainly Ponzi finance, meaning that interest rate charges are not paid but capitalized. We are sure that this is playing a huge and rapidly escalating role. To have some idea about its extent, we make a simple calculation.
Total domestic indebtedness in the United States now amounts to almost $40 trillion. An assumption of average interest rates of 5% is certainly very much on the low side. Still, it implies annual financing costs of around $2 trillion. Given last year an increase in national income by $628 billion, it should be clear that at present debt levels, current financing costs vastly exceed the increases in current income. To meet the difference, lenders capitalize interest rates, adding the sums to outstanding credits.
The explanation is self-evident. Borrowers and lenders don’t care about cash flow and current income to meet debt service, because they count on the stability of the underlying asset values. Their stability has become the key question. Considering the vast difference between the growth of national income and the estimated annual financing costs of the debt mountain, we are sure that Ponzi finance is the single biggest item behind the credit expansion in the United States, and it is rising fast. Of course, this money is not for spending in the economy.
Looking for the causes of the current debt explosion in the United States, the monstrous trade deficit finally needs mentioning. There is much talk about its foreign financing. But it requires domestic financing in addition, because it diverts domestic spending to foreign producers, implying a corresponding loss to domestic producers. Essentially, credit creation has to offset this drag.
Far more difficult is the second question, concerning the unusual, drastic shortfall of employment and income growth in this recovery.
Essentially, this must have its main reason in the economy’s most unusual growth pattern. Credit could not have been more abundant, but its effects may differ diametrically from credit expansions in the past. Use of credit for transactions outside the national product for the purchase of existing assets has vastly outpaced the use for spending on goods and services.
In the case of many financial transactions, among them mergers, acquisitions and all types of carry trade, the borrowing and spending evidently adds nothing to the economy’s income stream. All this goes a long way to explaining the tremendous divergence between rampant debt growth and sluggish income growth. But it does not go all the way.
This is the obvious part. Few people seem to realize that there is also a diametric difference in economic effects between borrowing for capital investment and borrowing for consumption. After careful scrutiny, we have come to the following two conclusions:
First, credit for capital investment generates cumulative employment and income growth with minimal debt growth; second, credit for consumption generates compounding debt growth with minimal employment and income growth.
Consider what happens when businesses borrow for fixed investment. The first effect is that producing the buildings, the plant and the equipment creates corresponding employment, incomes and tangible wealth. Then, when these capital goods are installed, they create additional supply, employment, productivity and incomes.
Investment spending has distinguishing features that endow it with singular impetus for economic growth: One is that it impacts the economy successively from the demand and supply sides, and the other is that it implicitly creates current and future incomes.
And most importantly, investment spending is through depreciations self-financing and of recurrent nature in the long run. As a rule, depleted plant is rebuilt with new technologies. Capital spending is really the critical mass in the economic growth process, generating all the things that make for rising wealth and living standards.
Now compare this multitude of effects due to investment spending with the effects of consumer credit. Once spent, their economic effects quickly peter out. Any new increase in spending requires new credit. At the same time, running interest costs either rapidly compound in the balance sheet or reduce current income. Consumer borrowing principally makes economic sense only for people who can look forward to higher future income. But in the United States, it is used for the opposite purpose: to offset missing income growth.
Last year, U.S. private households added $374.4 billion to their disposable income and $1,204.7 billion to their outstanding debts. Inflation-adjusted disposable income grew $115.7 billion. It is a growth pattern with exploding debts and imploding income growth.
To make our point perfectly clear: The present U.S. economic recovery has never gained the traction that it needs for self-sustaining economic growth with commensurate employment and income growth. As to its main cause, all considerations lead to the conclusion that it must reside in the protracted, appalling shortfall in business fixed investment. Investment spending is, really, the essence of economic growth.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning