"...The underlying basic fact is that Americans, in the aggregate, have been spending and continue to spend in excess of their current income. What is wrong with that? Why should excess consumption strangle economic growth? The short answer is, consumer spending in excess of income inherently means also in excess of production, and this part of consumer spending essentially emigrates to foreign producers, adding nothing to the U.S. GDP..."
Americas economic recovery and its likely strength have been and remain the central preoccupation in economics around the world. In the consensus view, the U.S. economy will record in this year's second half its strongest pace of growth since the late 1990s. According to a monthly survey of 53 economic forecasters conducted by the Wall Street Journal Online, its seasonally adjusted annual growth rate during the current quarter will be 4.7% and 4% in the fourth quarter.
Consumer spending, propelled by the housing and mortgage refinancing bubble, is supposed to lead the recovery. It is growing, yes. But even here acceleration is completely missing. There were temporary boosts from promotion programs by the car manufacturers and also from tax cuts and tax refunds, but there always followed a new relapse.
Consumer borrowing is on the rampage as never before. In 2000, at the height of the bubble, it increased by $558.8 billion. This accelerated during 2001, the recession year, to $614.6 billion, and in 2002 to $771.8 billion. During the first two quarters of 2003, it has further soared to $837.2 billion and $1,000.2 billion, at annual rate.
The debt binge is working, for sure. But on closer look, we notice that more and more debt produces less and less consumer spending.
The fact is that the growth rate of consumer spending during the past fours quarters (2.9% y-o-y) is far below its average rate of growth (more than 5%) in prior post recession periods.
It is true that creating the greatest consumer borrowing binge, as well as the greatest monetary and fiscal stimulus, in history has so far prevented a deeper recession in the United States. However, this bubble has rapidly diminishing effects, and above all, it has completely failed to induce an accelerating upward movement. All the acceleration in real GDP in the second quarter that is being hailed as proof of an ongoing recovery has come from government spending and the hedonic pricing of computers. Take the two away, and there is more economic sluggishness.
The Decisive Failure
This has an obvious reason -- all the monetary and fiscal stimulus has flagrantly failed to revive the economic components that are indispensable for a true self-sustaining economic recovery. For that it needs sustained growth in employment, personal income, business fixed investment and profits. But all these key ingredients of economic growth remain flat or even negative.
In contrast to previous business cycle recoveries, in which personal income used to increase strongly, this time it has remained sluggish. Instead, the rise in consumer spending is being exclusively driven by heavy borrowing.
But as just expounded, consumer spending has been distinctly slowing, even though consumer borrowing is beating ever-new records. There can be little doubt that the sharp rise in long-term interest rates is sure to implement still more restraint.
Still, the consensus is convinced that the U.S. economy's sustained recovery from slow growth has definitely started. We keep reading such reports with utter amazement because this assessment flagrantly conflicts with the very weak economic data from official sources.
We have realized that this prevailing optimism about the U.S. economy owes everything to a number of indexes that we call artificial data, such as the Conference Board, Institute for Supply Management, the University of Michigan consumer sentiment, including in particular the stock market, all ranking as early indicators. American economists and investors are unusually obsessed with the idea of spotting a change in the economy before it happens.
In the past few months most of these early indicators have been grossly upbeat in comparison to the official data. Just recently, the Federal Reserve published its production index for August. It inched up from 110.1 to 110.2, and was 1% below its level a year ago. The output of consumer goods even dipped 0.2%. There was a single big increase y-o-y: defense equipment, up 6.5%.
This protracted stagnation of production, fully two years after the recession ended, compares with steep increases by 7-8% during the first two years after recessions in past cycles.
The decisive point here really is the growing disparity between demand growth and production in the United States. The most striking example of this gross imbalance between supply growth and demand growth are the disparate paths of retail sales -- up 6.3% y-o-y -- and manufacturing -- down 1.6% y-o-y. We think this particular gross imbalance is symptomatic of the situation across the whole U.S. economy. America has the most powerful credit machine in the world, but it lacks saving and investment.
The comparison between the two figures says that over the past year the entire increase in the U.S. domestic demand for goods, as reflected in sharply rising retail sales, went to foreign producers. Literally nothing of that demand growth ended with domestic producers.
Essentially, this fact raises a few critical questions about the supposed existence of large excess capacities. Why are they not used to meet the rapidly rising demand? There are two possible answers: first, the excess capacities do no exist; second, they exist, but they are not competitive.
Years of Rampant Overconsumption
Manifestly, America's bubble economy of the late 1990s had its center in the most profligate consumer borrowing and spending binge in history. In particular the fact that consumption soared as a share of GDP towards 90% and higher, as against a long-term ratio of about 67%, bears this unmistakably out.
This really is the U.S. economy's key imbalance that is obviously the root cause of its protracted sluggishness. The underlying basic fact is that Americans, in the aggregate, have been spending and continue to spend in excess of their current income.
What is wrong with that? Why should excess consumption strangle economic growth? The short answer is, consumer spending in excess of income inherently means also in excess of production, and this part of consumer spending essentially emigrates to foreign producers, adding nothing to the U.S. GDP.
But that is not all. At the same time, the overconsumption creates a variety of growth-impairing imbalances in the economy, both on the macro and micro level. Among them the most spectacular and also the most impeding to economic growth is the monstrous trade deficit.
In America, it is the consensus view that such a deficit is simply typical and normal for a country that is growing faster than the rest of the world. That is not at all true. The normal experience over decades and centuries is the exact opposite. Fast-growing economies used to have an export surplus, like Germany and Japan in the earlier postwar decades.
The reason is that economies with high economic growth used to be high-investment and high-savings countries. They chronically consume less than they produce, and that makes for the export surplus. America, in contrast, is a low-investment and low-savings country where consumption has now exceeded current production for many years. That, and nothing else, is the key cause of the trade deficit.
The Growth and Profit Killer
The decisive adverse effect of the huge trade deficit on U.S. economic activity arises from the fact that the money spent for purchases abroad represents for American businesses an equivalent loss of revenue that essentially hurts profits. It actually devastates the profits of American corporations when the money spent abroad comes from the wage bill of American businesses. And that actually means a double whammy for U.S. profits. U.S. businesses have the wage costs and forego the revenue.
Manifestly, the capital inflows are not undoing these adverse effects of the trade deficit on domestic incomes and profits. They do not flow into the real economy, building factories; they flow into the financial markets, overwhelmingly purchasing existing financial and real assets. And that means the absence of any income effects.
It is the traditional American view that consumption, being by far the biggest component of GDP, is therefore also its most important component that essentially leads recoveries. America had in the past years more consumption than ever, but capital investment and profits disappeared.
That is precisely what European growth theory expects to happen. If consumption grows to excess, it crowds out investment and spills over into imports. With its tremendous size, the trade deficit is America's main growth and profit killer.