The Daily Reckoning PRESENTS: The U.S. 'recovery'
continues... but tensions are billowing beneath its surface.
How long before they unleash the winds of fury - causing
the consumer to retrench, inflation and interest rates to
surge, and the dollar to fall precipitously?
SIGNS OF A HURRICANE
by Marc Faber
The present "strong" recovery phase in the U.S. economy
won't last for long, as it is totally artificial. There are
simply too many imbalances in the system - as reflected by
a record low national saving rate, record household debts,
and record trade and current account deficits - for this
recovery to lead to sustainable strong growth that would
justify the present stock valuations.
According to economic theorist Joseph Schumpeter, economic
recoveries that are purely a consequence of fiscal and
monetary stimulus must ultimately fail. Schumpeter writes:
"Our analysis leads us to believe that recovery is sound
only if it does come from itself. For any revival which is
merely due to artificial stimulus leaves part of the work
of depression undone and adds, to an undigested remnant of
maladjustments, new maladjustments of its own."
My colleague Peter Bernstein correctly points out the
complexity of the issues involved: "Private sector saving,
private sector investment, household consumption,
government spending, government revenues, capital flows,
and trade balance all react upon one another - often in
surprising fashion. We live in a complex system: each piece
tends to function as both symptom and cause." And while I
cannot discuss here Bernstein's entire analysis of economic
data, which he himself admits is "confusing," I would like
to point out that he also is "certain" that "current trends
are not sustainable."
Bernstein writes: "The imbalances are now enormous, far
more glaring than at any point in the past. Furthermore,
the linkage of the parts are so tightly knit into the whole
that reducing any one imbalance to zero, or even
compressing them all to a more manageable level, appears to
be impossible without a major upheaval. A hitch here or a
tuck there has little chance of success. When it hits, and
whichever sector takes the first blows, the restoration of
balance will be a compelling force roaring through the
entire economy - globally in all likelihood. The breeze
will not be gentle. Hurricane may be the more appropriate
metaphor."
Part of the problem the United States is facing is the
long-term decline in the U.S. national saving rate
(including household saving, corporate cash flows, and the
government's budget surplus or deficit). As a percentage of
GDP, there was an improvement in the national saving rate
between 1993 and 2000 due to higher taxes and a swing in
the federal budget toward surplus... but thereafter, the
national saving rate plunged. Over the same time period,
real personal consumption expenditures as a percentage of
GDP declined modestly between 1988 and 1998, but soared
between 2000 and 2003 to a record.
Now, in past recessionary periods (1973-74, 1981-82, and
1990), the tendency has been for real personal consumption
expenditures as a percentage of GDP to decline modestly
and, in the process, create "pent-up" demand - which then
leads to sustainable growth. But at present, given the low
national saving rate and record real personal consumption
expenditures as a percentage of real GDP, there seems
little room for consumers to boost their expenditures
significantly... unless households increase their
indebtedness much more, or households' net worth or income
rises substantially. U.S. consumers have increased their
spending for an unprecedented 47 quarters in a row. (The
last downturn was in the fourth quarter of 1991.)
More recently, consumer spending rose largely as a result
of higher borrowings. U.S. household sector debt to net
worth is at an all-time high, having expanded very rapidly
since 2000, when the economic expansion started to stall.
And while it is true that the cost of servicing the debt
isn't excessive, this is only due to the sharp decline in
interest rates we have had since the early 1980s and
especially after 2001.
Meanwhile, household income has declined significantly.
Hourly earnings increases have been declining sharply since
late 2002 - most likely because of the accelerating trend
to manufacture in low-cost countries and outsource services
to countries such as India. In fact, real wages have
actually been in decline since 2001; in the 12 months ended
September 2003, they fell 0.2%. Some recovery in real wages
is possible... but given the low level of hourly earnings
increases, the fading impact of the tax cuts after January
2004, and lower refinancing activity, consumption is
unlikely to receive much of a boost from the households'
income.
Then again, actual figures for real wages and salaries are
far lower than those reported, as the U.S. government has
been purposely understating inflation figures by a wide
margin. Moreover, overseas competition for manufacturing
and services is here to stay, and inflation may actually
pick up. These factors lead me to believe that real wages
could actually decline further.
So where does all that leave us? Consumption could
theoretically be increased, if not through income growth,
then through a further decline in the national saving rate
and additional consumer borrowings. But for households'
borrowings to keep on expanding, asset prices - including
housing and equities - must continue to appreciate, or
interest rates will have to decline much further!
In other words, rising asset prices, which supported
additional borrowings, have largely been driving the U.S.
recovery (though the government also made a small
contribution by boosting spending). This is particularly
true of the housing sector, where rising home prices
allowed households to increase their mortgages and provided
them with additional spending power.
I hope you appreciate the precarious nature of this state
of affairs. The entire U.S. economy is depending on high
"asset inflation" in order to stay afloat! Only if asset
prices continue to rise at high rates can consumers
maintain their borrowing binge.
But trouble seems to be brewing in the American wonderland.
First of all, it would appear that the housing sector is
slowing down. The Merrill Lynch Housing Index has declined
sharply since August, and the growth rate in real estate
loans has slowed to an 11.5% year-over-year growth rate,
down from this summer's 18% growth rate. Refinancing
activity is down by 70% from its summer peak, and real
estate loans at banks have begun to contract. But why
worry? Most recently, the tireless and imaginative American
consumer offset slower real estate loan growth with a sharp
jump in consumer loans carrying a higher interest rate!
The question that arises is, of course, how sustainable is
an economic recovery that is driven by a declining saving
rate and strongly rising additional borrowings - which in
turn depend on rising home and equity prices, especially
since the combination of these factors has led to a sharp
deterioration in the U.S. trade and current account deficit
and hence to a weakening dollar? Please also note the
doubling of the trade deficit with developing countries
(especially due to U.S. imports from China).
This highly artificial recovery is, in our opinion, not
sustainable for very much longer. Even so, we should all
realize that the Fed is fully aware that asset prices must,
under no circumstances, be allowed to decline. In fact, the
Fed will try to make them appreciate even further through
highly expansionary monetary policies, as stagnating home
prices alone would endanger the recovery, while declining
prices would be altogether unbearable for the highly
leveraged household sector, whose debt to net worth would
soar in an environment of declining asset prices.
So, we are in a situation where the imbalances are likely
to worsen further until something gives. At some point, the
American consumer will retrench voluntarily, which might
slow down the expansion (but probably not much) of the
trade and current account deficit. Or, it is possible that
the consumer will be forced to retrench through a rapid
loss of the U.S. dollar's purchasing power. Rising
inflation rates would then inevitably lead to higher
interest rates, and most likely also to falling real
household income, as wage increases would be unlikely to
match the rate of inflation.
Therefore, a voluntary or involuntary consumer retrenchment
could badly derail the Fed's inflationary monetary
policies. I am not sure exactly how the present imbalances
will play themselves out, since, as Mark Twain remarked, "A
thing long expected takes the form of the unexpected when
at last it comes." But I am certain that Peter Bernstein
will be proved right when he writes, above, that the breeze
accompanying the restoration of balance will not be
"gentle"... but will likely take the form of a financial and
economic hurricane.
Regards,
Marc Faber
for The Daily Reckoning
Editor's note: Dr. Marc Faber is the editor of The Gloom,
Boom and Doom Report. Headquartered in Hong Kong for 20
years and now based in northern Thailand, Dr. Faber has
specialized in Asian markets and advised major clients
seeking down-and-out bargains with deep hidden value,
unknown to the average investing public.